*By Christophe Barraud, Chief Economist & Strategist at Market Securities
According to TrackInsight data, since the beginning of the year, investors have raised their exposition to “U.S. Bonds ” ETFs with inflows recently reaching a new YTD high. The trend gained traction over the last few days as market participants expect the Fed to cut rates soon.
In a context where global uncertainty has risen significantly (trade/tech war between U.S. and China; migration crisis between the U.S. and Mexico; trade tensions between the U.S. and India) and U.S. inflation expectations have weakened drastically since the end of April, speculation about Fed rate cuts has intensified, supporting investors’ appetite for U.S. bonds.
According to CME FedWatch Tool, the probability of at least three rate cuts by the end of the year is now above 55% (vs 2% a month ago). Looking at the possible first move, the CME FedWatch Tool show that there is now more than 70% chance of a rate cut at the Fed’s July 31 meeting (vs 16% a month ago), despite the meeting not being followed by an update of FOMC forecasts.
Even if July looks a bit early in my view, several factors could push the odds higher to the extent that Fed officials look determined to support growth. Earlier this week, Federal Reserve Chairman Jerome Powell signalled an openness to cut interest rates if necessary, pledging to keep a close watch on fallout from a deepening set of disputes between the U.S. and China. In addition, Federal Reserve Vice Chairman Richard Clarida said the economy is in a good place but he and his fellow central bankers are willing to take action if conditions change. Finally, Federal Reserve Governor Lael Brainard also signalled an openness to lowering interest rates, yet, she didn’t indicate such action was imminent.
Therefore, investors will look closely at near term trade developments. As a reminder, to address the emergency at the Southern Border, Trump administration proposed tariffs on all goods imported from Mexico (starting from June 10) that could hit 25% by October 1st (if there is no concrete solution). As soon as June 16, India could implement retaliatory duties in response to last year U.S. steel and aluminium tariffs. Finally, Trump’s administration told China it could face tariffs on all its exports to the U.S. Under a process outlined by U.S. officials, the new tariffs would not take effect until late June at the earliest (close to the G20 meeting on June 28-29).
Finally, focusing on data, two employment reports will be scrutinized before July meeting (the first one on Friday and the second one on July 5th). Latest ADP employment report showed that U.S. private employers hired at the slowest pace in more than nine years in May. Also interesting, the first estimate of 2Q GDP will be released a few days before the July Fed meeting. At this stage, expectations also remain contained with Atlanta nowcast model pointing to a print of 1.3% QoQ Annualized (vs 3.1% in 1Q 2019).
To summarize, the bond market is likely to remain very sensitive to trade news and U.S. economic data in the coming weeks with a risk that disappointing numbers push the Fed to act as soon as July.
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