Trade escalation balloons recession risks, Fed likely to cut as early as July

A significant escalation in the ongoing viral trade war between the world’s two economic behemoths has increased the risks of a global recession, which also dramatically ballooned the chances of a policy easing by the Federal Reserve this year.

However, the U.S. central bank lacks tools needed to avert another major downturn and a financial crisis. With the current Fed funds rate of 2.25-2.5 percent, it seems difficult for the Fed to avert a plausible next recession.

In September 2007, the Fed funds rate was around 5.25 percent and the Fed had reacted aggressively to the recession shocks, although failing to prevent the “Great Recession”. With such a timid policy rate, the problem seems much bigger than before.

Fed Chair Jerome Powell in his speech early June, said the central bank would act "as appropriate" to address trade war risks, inviting a conceivable interest rate trim. That is the second unexpected shift in the Fed's language after they changed their bias in January this year.

Futures markets are pricing over 80 percent chance of a Fed rate cut as early as July, and one more in October.

“The cycle is shaped by the interplay between trade tensions and policy easing. Our base case is that policy easing in China and a Fed that pauses for some time will be enough to offset the adverse impact from a temporary re-escalation of trade tensions. However, uncertainty remains high and risks are skewed to the downside,” said Chetan Ahya, chief economist and global head of economics at Morgan Stanley in a note.

“Talks stall and no deal is agreed upon. The US imposes tariffs on all China imports and China responds by imposing 25 percent tariffs on all US imports while restricting SOE purchases from the US. With this shock to the global economy, even though the Fed cuts rates all the way to zero by spring 2020 and China embarks on aggressive monetary and fiscal stimulus, these measures can’t prevent a global recession.”

It is worth noting that most economists expect the U.S. will hit another recession probably in the next two years. With trade conflict going viral, it fuels fears of a worse recession than that seen in 2008; that has brutalised financial markets, with the S&P 500 suffering the worst since 2010.

“Disappointing economic data and the escalation of the U.S.-China trade war has led to further inversions of the U.S. Treasury yield curve. Therefore, the yield curve continues to point to a recession in the second half of next year. According to our model, the probability of a recession is now 69 percent by September 2020,” noted Philip Marey, senior U.S. strategist at Rabobank.

“For now, we have a run-of-the-mill recession in our baseline forecast, expressed as modestly negative GDP growth in the third and fourth quarters of 2020. What could make the recession deeper and longer? Usually this occurs if a recession is accompanied by a financial crisis.”

The U.S. and Chinese economies depend largely on domestic expenditure that accounts for about 70 percent of their respective countries’ economic growth to weather out any drag from the invincible ongoing trade war.

In the first quarter of this year, the U.S. economy expanded at an impressive rate of 3.2 percent, but is forecast to lose momentum and grow below 2.0 percent through next year. Some economists are predicting a recession, defined as a negative economic growth for two consecutive quarters, as early as March 2020.

“It is unlikely that there will be a deal between the U.S. and China at the G20 summit in late June. Consultations on the trade conflict are no longer taking place and the statements made by the heads of state of the two largest economies in the world are currently more likely to create the atmosphere of an ice age. We have therefore lowered our growth forecast somewhat, while inflation is likely to be slightly higher than previously assumed,” said Christine Schäfer, head of economic analysis at DZ Bank.