Trade disputes may alter Fed plans to raise interest rates


NEW YORK • The relentless flattening of the US yield curve could be poised for a breather, as investors look for signs this week that escalating trade disputes will alter the US Federal Reserve’s (Fed) plans to lift borrowing costs.

Last Thursday’s release of minutes from the central bank’s June meeting looms large in a holiday-shortened week, after two Fed presidents warned that trade friction is weighing on businesses and clouding the economic outlook. The next day brings a US deadline to slap US$34 billion (RM137.36 billion) in tariffs on China, a threat that Beijing has already pledged to retaliate against.

The 10-year US Treasury yield fell the past three weeks, shrinking its spread over two-year debt to the narrowest since 2007. Any hint that the Fed may pull back from plans to hike twice more this year — as officials signalled in June — could slow the curve’s march toward inversion.

Barring that, the latest monthly job-market reading at the end of week stands to hammer home that the economy is solid enough to warrant tighter policy.

“The minutes will be important because we’ll get a further idea about what kind of caution is shaping into the Fed’s thinking regarding the effects of the trade war,” said Ben Emons, chief economist and head of credit portfolio management at Intellectus Partners. “There is a group that already wants to pause hiking. If the market senses a bigger campaign for that, then traders will lower the probability for a third or fourth hike and that should at least moderate the curve flattening.”

The 10-year note yields 2.86%, down from the 2018 high of 3.13% set in May. The two- to 10-year yield spread is about 33 basis points (bps), with the gap between five and 30 years at about 25bps, also close to the smallest since 2007. The shape of the curve is drawing scrutiny because inversion has been a reliable indicator of recessions.

The curve’s contraction gained momentum last month as policymakers lifted rates and raised their projections to a total of four increases for the year. The Fed’s preferred inflation gauge has been at or above its 2% inflation goal for three straight months, backing the case for more aggressive tightening.

Still, the economic hit from tit-fortat tariffs creates risk.

“Changes in trade policy could cause us to have to question the outlook,” Fed chairman Jerome Powell said at a European Central Bank conference on June 20. Last week, St Louis Fed President James Bullard said he’s hearing “full-throated angst” from companies. And the Atlanta Fed’s Raphael Bostic said businesses are “extremely concerned about the prospects of a trade war”.

For now, traders are pricing in another rate hike in 2018, with some chance of a fourth.

Strategists are also looking to the minutes for insight into the Fed’s June tweak to the interest rate on excess reserves, or IOER. Last month, officials lifted it by less than they hiked their policy rate, amid a drift in the funds rate to the higher end of their target range. One key question is hanging for investors: Whether that move is a one-off adjustment.

“We expect that the Fed will need to elaborate on their decision to lower IOER in the target range and hope that the Fed will finally start to signal their preferred end state for the Fed’s balance sheet,” Mark Cabana, a Bank of America Corp rates strategist, wrote in a note.

However, the Fed minutes unfold, the world’s biggest debt market may be set for volatility during a week when many traders are braced for the start of the summer doldrums. If it doesn’t come from US President Donald Trump’s next big decision on trade, there’s always the jobs data.

US markets are closed on July 4 for Independence Day (they’ll also shut early on July 3).

The latest gauge on the labour market is the highlight for economic indicators.

• July 2: Markit US manufacturing Purchasing Managers’ Index (PMI); construction spending; Institute for Supply Management (ISM) manufacturing, employment, prices paid and new orders.
• July 3: Factory orders; durable and capital goods orders; wards vehicle sales.
• July 4: MBA mortgage applications.
• July 5: Challenger job cuts; ADP employment; jobless claims; Bloomberg consumer comfort; Markit US services and composite PMIs; ISM non-manufacturing composite; Federal Open Market Committee minutes.
• July 6: Trade balance; payrolls data.

The US will issue US$48 billion of three-month bills, US$42 billion of six-month bills and US$35 billion of four-week bills, all on July 2.