Investors Shouldn't Count on the Fed to Be the Knight in Shining Armor

It seems that after May’s trade war turmoil, investors are looking for the Federal Reserve to be the knight in shining armor to slay the next bout of market volatility with one strike from its rate-cutting sword. However, economists like Nathan Sheets, chief economist at asset manager PGIM Fixed Income, warn investors not put too much stock into this fairy tale.

“The Fed can mitigate some of the adverse effects, but I’m not sure the Fed is inclined to move fast enough or significantly enough to entirely offset the effects of this trade war. I think ultimately the solution or resolution of this has to come at the negotiating table between President (Donald) Trump and President Xi (Jinping), and between the United States and Mexico,” said Sheets.

“The Fed will do its best given where the economy is, but it would take a dramatic easing of monetary policy for them to fully offset these kinds of effects,” Sheets added.

In the meantime, bond investors are making more bold bets that the Federal Reserve could cut interest rates at some point in 2019. While economic data is portraying a solid picture of growth, the capital markets are getting roiled by a volatile May with U.S.-China trade spats coming to the forefront.

The Dow Jones Industrial Average is already reflecting a rate cut expectation with its latest win streak. Despite what the stock market is saying, some Fed officials are not forecasting a rate cut just yet.

“Confidence, especially business confidence, is fragile. It’s our job as policy makers to try to support it,” said Richmond Fed President Tom Barkin in a speech earlier this month. At the same time, he told reporters, “there’s not a strong case to move [rates]lower when growth remains healthy.”

The U.S. economy rebounded in the first quarter this year, beating analysts’ expectations of 2.5 percent growth with a 3.2 percent growth number. The GDP figure represents the strongest rate of growth for the first quarter in four years and matches the 3.2 percent growth experienced a year ago.

“While the (first quarter) boost from net trade and state and local government spending is unlikely to be repeated in [the second quarter], the main message is that private consumption and investment are slowing down only gradually,” said Brian Coulton, chief economist at Fitch Ratings, in a statement.

Despite strength in the U.S., the global outlook is different. Earlier this year, the IMF cut its global growth forecast to the lowest level since the financial crisis, citing the impact of tariffs and a weak outlook for most developed markets.

According to the IMF, the world economy will grow at a 3.3 percent pace, which is 0.2 percent lower versus the initial forecast in January.

“At this point, I’m a little concerned about global growth generally,“ said Dallas Fed President Robert Kaplan in an interview last week. He didn’t address any policy implications of a darkening outlook for trade conflicts. ”I’m not sure I have a great insight other than, I’m watching it,” he said.

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