The four days that could shake markets, and the world

A year ago financial markets were in a tailspin as the US Federal Reserve Bank raised rates for the fourth time in 2018. As the Fed meets for the final time this year this week, the settings are very different.

This time last year, the Fed was committed to the normalisation of US monetary policy, raising interest rates and shrinking a balance sheet bloated by its post-financial crisis purchases of bonds and mortgages. At that point, the trade war between the US and China was also still a skirmish, more rhetoric than large-scale action.

Federal reserve chairman Jerome Powell's comments at a press conference on Thursday could move markets.
Federal reserve chairman Jerome Powell’s comments at a press conference on Thursday could move markets.Credit:AP

In the final three months of 2018 the hawkish tone and actions of the US central bank triggered a 20 per cent plunge in the stock market. Bond yields plummeted as investors rushed to a perceived safe haven.

Within six weeks the Fed had abruptly reversed its stance, adopting a dovish tone that laid the groundwork for three rate cuts this year and, thanks to the September turmoil in the US repo market, a $US300 billion expansion of its balance sheet late in the year. The US sharemarket has rebounded 33 per cent to record levels.


The two-day meeting of the Fed’s Open Market Committee (FOMC) that starts on Wednesday in Washington isn’t expected to see the Fed announcing a rate move in either direction.

But that doesn’t mean the meeting has no significance for US and global markets. Any hint of a future move in either direction would cause tremors, if not something more substantial.

Any hint of a future move in either direction would cause tremors, if not something more substantial.

With the members of the FOMC (the body that decides the US equivalent of the Reserve Bank’s cash rate) unusually divided this year, the tone of the Fed’s statement and of comments at the press conference that its chairman Jerome Powell holds at the end of these meetings have unusual significance.

The meeting is being held against the backdrop of a decisive few days for the trade negotiations between the US and China.

Given that a significant strand of the explanation for the FOMC members’ continuing shift from hawks to doves this year has been the escalating trade dispute and its impact on US business investment and manufacturing activity, the outcome of those talks will colour the Fed’s future actions.

In the absence of a deal, or sufficient confidence that one can be struck, this Sunday the US will impose a 15 per cent tariff on the final $US160 billion ($235 billion) of China’s exports to the US yet to be levied.

The so-called ‘’Phase One’’ deal – one that involves the least contentious of issues for both sides while deferring the more difficult issues for future negotiation – has economic significance for the US that is greater than the level of imports the final tranche of tariffs would impact.

Hitting consumer goods

Overall, the US has so far imposed tariffs, ranging from 15 per cent to 25 per cent, on about $US360 billion of China’s exports. The final 15 per cent, however, would have much greater impact on consumers.

Bloomberg has estimated that 86 per cent of the products that would be affected — consumer goods like smartphones, laptops, toys and apparel – are sourced from China. By contrast, it calculated that only 7 per cent of the goods covered by the initial tariffs came from China.

The framework for the negotiations is a trade-off of a withdrawal of Sunday’s threatened new tranche and the rollback of the existing tariffs, or a lowering of their rate, in exchange for massive purchases of US agricultural products by China’s state-owned companies, assurances about access to China’s markets and some protections for US intellectual property.

China has consistently shown a willingness to do a limited deal while making it clear that ‘’Phase Two’’ – reforms to its economy that would unravel a centrally-directed model that leverages the state ownership of the key sectors of its economy – is unpalatable.

The two sides appear to be bogged down in haggling over how much farm product China will agree to buy, as well as how far the tariffs should be rolled back or the rates reduced.

Trump wants a really big number to claim victory in the trade war but China has baulked at committing itself to numbers that the US may not be able to produce and China has never previously consumed.

Given the trade war, broader tensions and the unpredictability of the Trump administration, China would also be reluctant to become over-dependent on the US, particularly as the trade conflict has seen it diversify its sources of key products like soy beans, dairy, pork and beef.

Phase One

The markets are punting on an eleventh-hour Phase One deal or, failing that, a temporary deferral.

There’s no expectation that the talks will completely break down (and little expectation that a more comprehensive deal will be struck this side of next November’s US elections, if ever).

Financial markets have shown acute sensitivity to every nuance of developments in the trade war.

If an agreement is reached by Sunday, or one appears near-certain shortly thereafter, the bullish “risk-on” mood of the markets will be sustained.

If there’s no deal, or if the Fed surprises by being more hawkish in the statements accompanying its expected decision to hold rates where they are, there’s likely to be turbulence and a flood of money out of equity markets and into bonds in a belated reprise of last year’s panicky final quarter.

The outcome of the trade talks also has the ability to move markets and impact a global economy that has been undermined by the trade war.

There’s a lot riding on the outcomes of the two sets of discussions over the next four days.

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