Trade truce clouds Fed and dollar outlook

A truce between the US and China, with a pledge to resume negotiations, has buoyed risk appetite so far. But trade wars haven’t gone away, and the big question for investors now is whether the Federal Reserve (Fed) will change its view on policy direction if trade wars do not worsen.

A key plank of chairman Jerome Powell’s argument at the last Fed meeting was that trade wars posed a risk to the outlook, and that the Fed might need to react in order to head off some economic weakness as a result of the conflict. The G20 meeting between US President Donald Trump and Xi JinPing merely resulted in the cancellation or postponement of $300 billion in tariffs on Chinese goods. Further negotiations are needed before the two sides can head towards a resolution.

Will the Fed lower rate cuts?

It is reasonable to expect the Fed to take a positive view of the G20 developments. As is usual, markets have gotten ahead of themselves regarding the outlook for rate changes. At the beginning of the year, Fed Funds Futures suggested that the bank would raise rates three times in the next year. A month ago, the price pointed to three rate cuts. The truth most likely lies somewhere in the middle of these two extremes, but whereas a 50 basis points (bps) cut was a possibility last week, now perhaps the Fed will opt for a 25bps cut.

Markets are a game of expectations, and a cut of 25bps, after such strong expectations of a bigger move, might not have the positive impact on equities and negative one on the dollar that many might think. Indeed, the 26bps cut might well see equities sell off on disappointment that the Fed has not moved strongly enough, while the dollar gains on the more ‘hawkish’ (relative to expectations) outcome.

Trade war cooldown: what’s next?

There is also the longer-term view to consider. If trade wars have cooled down for now, it would make sense for the Fed to take a more cautious approach, knowing that it could cut more later in the year and/or engage in renewed asset purchases. The Fed is being cautious, it is not in panic mode. Overreacting might produce the wrong effect, with markets beginning to worry that the US central bank thinks that the situation has worsened and will continue to do so.

Crucially, speculative longs in the USD have been declining since December. This dollar selling has driven the currency to a three-month low. If the selling continues, that would remain bearish for the dollar. Alternately, a less dovish view of the Fed, plus renewed weakness in the eurozone economies and elsewhere, might provide a reason for dollar longs to start building once again.

USD: what’s the outlook?

Interestingly, Bloomberg notes that short dollar positions have been rising in recent weeks – this could set the market up for a monumental short-squeeze should the Fed err towards a modest cut in rates. Investors seem convinced that the dollar will weaken, which in itself is enough to send a signal that some caution is warranted; at present, the uptrend since January is down, but not out, and if markets have reacted too quickly then a rebound in the dollar could be ahead.