It is incredible that just a few months ago most analysts were expecting at least two if not three interest rate hikes by the Federal Reserve. How quickly things change. Markets are pricing in at least a couple of rate cuts by the FOMC while US Treasury yields have fallen sharply as growth concerns have intensified, even as the hard economic has not yet turned that bad. Recession risks are once again being actively talked about as trade fears intensify, with President Trump threatening increased tariffs on both Mexico and China. As I noted earlier this week, trade tensions have escalated.
Reflecting this, core bond markets have rallied sharply, with 10 year US Treasury yields dropping by around 60bps so far this year, while bund yields are negative out to 10 years. Historically such a plunge would be associated with a sharp weakening in growth expectations and onset of recession. However, equity markets are holding up better; the US S&P 500 has dropped around 6.8% from its highs but is still up close to 10% for the year. Even Chinese equities are up close to 20% this year despite falling close to 13% from their highs. Equities could be the last shoe to fall.
In currency markets the US dollar has come under pressure recently but is still stronger versus most currencies this year except notably Japanese and Canadian dollar among major currencies and the likes of Russian rouble and Thai baht among emerging market currencies. On the other end of the spectrum Turkish lira and Argentine peso have fallen most, but their weakness has largely been idiosyncratic. In a weaker growth environment, and one in which global trade is hit hard, it would be particularly negative for trade orientated EM economies and currencies.
The US dollar has a natural advantage compared to most major currencies at present in that it has a relatively higher yield. Anyone wishing to sell or go short would need to pay away this yield. However, if the market is increasingly pricing in rate cuts, the USD looks like a much less attractive proposition and this is what appears to be happening now as investors offload long USD positions build up over past months. Further USD weakness is likely at least in the short term, but it always hard to write the USDs resilience off.
Going forward much will of course depend on tariffs. If President Trump implements tariffs on an additional $300 billion of Chinese exports to the US as he has threatened this would hurt global growth as would tariffs on Mexico. Neither is guaranteed and could still be averted. Even if these tariffs are implemented fears of recession still appear to be overdone. Growth will certainly slow in the months ahead as indicated by forward looking indicators such manufacturing purchasing managers’ indices, but there is little in terms of data yet to suggest that recession is on the cards.