What’s next for the Fed amid the US-China tariff dance?
As the investment world looks towards a Fed rate cut, we think policymakers are stuck between a rock and a hard place
[SINGAPORE] As widely expected, the US Federal Reserve kept its policy rates unchanged in the May meeting, with a target Fed funds range of 4.25 to 4.5 per cent. This was the third consecutive meeting in which the Federal Open Market Committee (FOMC) members kept policy rates on hold.
While policymakers made some tweaks to the FOMC policy statement, there had been nothing major. That said, the press conference carried a more hawkish undertone and reinforces the Fed’s comfort in staying cautious, in a wait-and-see mode.
First, Fed chair Jerome Powell reaffirmed that the central bank is in a good place as the US economy remains solid, expressing that the right approach is to wait for further clarity. Second, he also highlighted that the Fed is not in a position to act pre-emptively, unlike the 2019 rate cuts.
Third, the Fed acknowledged higher stagflation risks and the conflict between its dual mandate – price stability and maximum sustainable employment. When asked about this conflict, Powell mentioned that “without price stability, we cannot achieve the long periods of labour market strength”, suggesting that inflation might still be a key priority in this battle.
Cautious stance
We think macro developments since March’s FOMC meeting further justify the Fed’s cautious stance. Hard economic data (reported and measured data) has continued to diverge from soft data (surveys and sentiments). Broadly, the former remains resilient while the latter has steadily weakened, signifying growing economic weakness driven by concerns surrounding the trade and regulation uncertainties.
Broadly, we see positive hard data across key economic areas such as labour market and inflation in April. Non-farm payroll continues to grow, with job creation averaging around 148,000 a month year-to-date. The US unemployment rate has remained flat over the past two months, while jobless claims remain range-bound. Meanwhile, US inflation prints – both the consumer price index (CPI) and personal consumption expenditures – have also softened in March (and even April for CPI), pointing to easing price pressure pre-tariff.
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On the other hand, soft data has demonstrated signs of weakness, fuelled by the trade uncertainties. The widely watched ISM Manufacturing PMI has stayed in contraction territory (below 50) for several months, while the National Federation of Independent Business’ small business optimism index has also dropped to levels associated with economic weakness.
Inflation
Regarding inflation, the University of Michigan survey showed that inflation expectations – both short and long term – surged in April (and May). This can also be observed from April’s consumer inflation expectation index from Conference Board’s survey, which soared in April.
Considering the recent macro developments and ongoing uncertainties, we think the Fed’s recent decision to hold rates was no surprise. While the risk of a US stagflation has somewhat moderated given the recent US-China trade truce, we believe the situation remains fluid and do not discount the potential inflationary risk. To us, the Fed remains stuck between a rock and a hard place – holding rates to combat inflation or cutting rates to support growth.
We expect the Fed to remain cautious and is in no rush to cut rates unless macro data deteriorates. With the Fed being data-dependent, we think an accelerated weakening in the labour market data may convince policymakers to cut rates. That said, we are not there yet and should the situation materialise, the room for rate cuts may likely be limited given the inflation concerns.
Amid this policy and macro backdrop, we maintain our preference for shorter-duration fixed income, which should continue to generate attractive income while keeping duration risk low. Short-end rates, particularly one-year and below, should remain anchored and attractive given the cautious policy stance and potentially limited room for Fed rate cuts.
At the same time, long-term inflation risks may also be underpriced if higher tariffs go through. This would not only put upward pressure on long-end yields but also spur greater interest rate volatility, which can create wilder price swings for longer-tenor fixed income. In our view, long-end rates are not offering sufficient yield over the short-end to justify such risk.
For investors looking to add duration or lock in yields, we believe it pays to be selective. Corporate bonds provide better opportunities at the moment, as the yield pickup is more favourable on the longer end, with an upwards sloping corporate yield curve (compared to the US treasury curve). That said, amid the trade and growth uncertainties, it is prudent to climb up the credit ladder and we prefer higher-quality corporate bonds.
The writer is a portfolio manager of the Bondsupermart team at iFast Financial, the Singapore subsidiary of SGX mainboard-listed iFast Corporation
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