Trump targets Mexico, hits the Fed

Interest rate expectations have moved significantly over the past week following President Trump’s tweet that he was putting tariffs on Mexico. The market is now pricing in nearly three rate cuts of a quarter point each this year from the US Federal Reserve (Fed). Only a week ago the market was pricing in just one.

Our view has been that the Fed would ease, but not until next year when there would be more evidence of a slowdown in activity.

Alongside the stalling in the US-China talks, the latest tariffs represent a ratcheting up of trade tensions and would hit growth, not just in Mexico but also in the US. Macro-models suggest US GDP would be some 0.7 percentage points weaker in 2020 than otherwise. This would put the US in recession on our forecasts.

As always with President Trump one cannot be certain whether his latest move is part of a bargaining strategy and that ultimately he will not follow through. The problem for the Fed is that the market seems to have decided he means it. Consequently it is more difficult for the central bank to push back without triggering considerable financial volatility.

Looking at the impact on the economy, higher tariffs hit trade but much of the near-term effect is likely to be through weaker confidence and falling equity markets, areas the Fed can influence.

Chair Jerome Powell offered markets some reassurance yesterday when he said the Fed was monitoring the implications of the trade negotiations and would act appropriately to sustain the expansion. Meanwhile, there are signs that the economy is cooling  and inflation remains low so there is little to stop the Fed making a precautionary “insurance” cut. This could come in late July but more likely September.

It remains to be seen whether Trump’s threats on tariffs achieve a resolution of the immigration crisis with Mexico, but it may get him the rate cut he wanted from the Fed.