Does 750 Point Dow Drop Equal 50bp Fed Cut?

There are 2 words to describe market sentiment right now – panic and fear. The Dow Jones Industrial Average dropped more than 700 points today, its biggest one-day slide in 2019. Last week President Trump announced new tariffs on China and overnight, China raised the stakes by allowing its currency to fall to a record low, breaching the 7.0 USD/CNY rate in the process. In addition to devaluing its currency, China also asked its state buyers to halt all US agricultural imports. President Trump responded by calling China a “currency manipulator,” raising fears that he’ll order the Treasury to slap this label on China officially. If the Treasury were to brand China a currency manipulator for the first time since 1994, it would give Trump the ammo to restrict Chinese imports further. These antagonistic actions and comments are a sign that the worst could be yet to come as Trump promises to “tax the hell out of China.” The sell-off in the Dow and sharp decline in Treasury yields reflects the market’s concerns about the impact on US business and consumers. Consumers will feel the pain through higher prices and falling investment values. US businesses will feel the pinch in earnings that could lead to less business investment and hiring.

President Trump described last week’s interest rate cut by Fed Chairman Powell as disappointing and inadequate. So he took matters into his own hands and did what the Fed could not do – weaken the dollar, drive yields lower and set the stage for more easing. Between the tariffs and the 800 point drop in the Dow today (1,400 points since last Wed), investors are pricing in not one but two rate cuts this year. Fed Fund futures show the market pricing in 100% chance of a 25bp cut in September followed by 100% chance of another 25bp cut by December. This is a dramatic shift from Wednesday when the market was only pricing in a 60% chance of one more quarter point cut in 2019.

There’s no question that Trump’s trade war will force the Fed to act. If the tariffs are imposed on September 1st, we see another rate cut in September or October. But as we’ve seen on many occasions including earlier this year, anything can happen between now and then. If the markets fall too much, Trump could retract his threat and put the tariffs on hold. We don’t expect a positive turn this week so the US dollar and risk currencies are vulnerable to deeper corrections. USD/JPY, which has fallen below 106, could breach 105.

Trump’s tariffs will also affect the Reserve Bank of Australia’s outlook. AUD/USD is trading at an 8 month low ahead of tonight’s RBA rate decision. The last time the RBA met, they lowered interest rates for the second time this year to a record low of 1% and RBA Governor Lowe said “the board is prepared to adjust interest rates again if needed to get us closer to full employment and achieve the inflation target.” Economists are not looking for 3 back to back rate cuts because there have been more improvements than deterioration in Australia’s economy since the last monetary policy meeting. Retail sales are up, inflation is up, full time employment rose strongly in June and manufacturing activity is improving. Believe it if you will but Chinese data also ticked higher. So based on Australia’s economic performance alone, another immediate rate cut is not needed. However, the tariffs on China and the weaker Yuan are game changers for Australia and will harden the RBA’s resolve to ease. Like the last cut, they’ll probably choose to wait until the tariffs come into effect before they lower rates but they’ll set the stage for more stimulus this year.