As late as last December, Goldman was expecting four rate hikes in 2019. Then, as recently as mid-June, the “smartest men in the Goldman room”, did not expect the Fed to cut rates at all in July and September. Of course, all that changed when it became clear that “Powell has thrown in the towel”, and will follow the demands of the president and the whims of the market, resulting in the first “mid-cycle” rate cut last month in over a decade.
And now, Goldman has once again shown that its forecasting ability is the functional equivalent of a coin toss, when late on Monday night Goldman economist David Mercile said Goldman no longer expects the US and China to agree on a deal to end their trade war before the November 2020 presidential election as policymakers from the world’s largest economies are “taking a harder line”.
On the US side, press reports indicate that President Trump made the decision to raise tariffs despite the strong objections of all but one of his advisors, Director of the Office of Trade and Manufacturing Policy Peter Navarro, and threatened to lift tariff rates even further to “well beyond 25%” if necessary. Just this evening, the Treasury Department took the further step of designating China a currency manipulator. While we had previously assumed that President Trump would see making a deal as more advantageous to his 2020 re-election prospects, we are now less confident that this is his view.
On the Chinese side, the currency depreciation past the symbolically important level of 7 yuan per dollar and the announcement that China has suspended purchases of US agricultural goods added up to a swift and meaningful response. News reports suggest that Chinese policymakers are increasingly inclined not to make major concessions and instead to wait until after the 2020 US presidential election to resolve the trade dispute if necessary.
As a result, a trade deal now looks far off. Press reports indicate that trade talks are going poorly. The White House appears increasingly unlikely to accept a deal that does not include major structural reforms, and Chinese policymakers appear increasingly unlikely to accept a deal that does not include a major immediate reduction in tariffs. This has made a more symbolic deal consisting mainly of a Chinese commitment to buy more US exports less realistic.
As a result, Goldman’s “base case is now that no deal will be reached before the 2020 election. We expect the newly announced 10% tariffs on the last $300bn to remain in place on Election Day, and other forms of tit-for-tat retaliation are possible along the way.”
In parallel with this extended trade war, the bank has extended its prior forecast of two rate cuts in 2019, and now expects two back-to-back rate cuts from the Fed: “In light of growing trade policy risks, market expectations for much deeper rate cuts, and an increase in global risk related to the possibility of a no-deal Brexit, we now expect a third 25bp rate cut in October, for a total of 75bp of cuts.”
Goldman explains that “the balance of risks has shifted enough to make a third 25bp rate cut in October the most likely outcome, for a total of 75bp of cuts including the July cut.” Specifically, for the September meeting, Goldman sees a 75% chance of a 25bp cut, a 15% chance of a 50bp cut, and a 10% chance of no cut. For the October meeting we see a 50% chance of a 25bp cut, a 10% chance of a 50bp cut, and a 40% chance of no cut.
This is contrary to the message the Fed was trying to convey, as Mericle thinks “the FOMC most likely envisioned at its July meeting that rate cuts would eventually total 50bp. This strikes us as the best guess of what Chair Powell meant by a “mid-cycle adjustment” to “adjust policy to a somewhat more accommodative stance over time,” as well as the most likely compromise on a divided committee in which many participants were skeptical of the case for cutting at all.”
So picking up where Goldman left off last week when it tried to infer what it would take for the Fed to stop cutting rates, the bank now says that “for rate cuts to stop, Fed officials will eventually have to withstand White House demands and perhaps bond market expectations as well” and it adds that by the December meeting “the FOMC is likely to stop.”
By that point we expect core PCE to stand at 1.9% as of the October print, with tracking estimates based on the November CPI at 2%. We also think some FOMC participants would push back harder against rate cuts that summed to 100bp or more, an amount that in the past has been reserved for situations in which there was a strong chance that the economy was already headed into recession.
Of course, this being a Goldman forecast, the most likely outcome is whatever Goldman does not expect as a baseline (sorry, but that’s just the bank’s own dismal predictive track record). And amusingly enough, Goldman concedes as much saying that it sees “risks in both directions.”
There is still some chance that the White House will not proceed with the latest threatened escalation, perhaps in view of recent market moves. In the other direction, further increases in tariff rates down the road—say from 10% to 25% on the upcoming round—would increase the odds of deeper cuts.
It is hardly a surprise that Trump would like to keep escalating the trade war just to get even more rate cuts, but the emerging risk as BofA explained yesterday is that Trump slows down the US, and global, economies so much that no amount of easing, or bond buying, by the Fed will be able to offset it. One thing, however, is certain: the next 16 months will be especially interesting for markets.