This article is taken from our FREE daily investment email Money Morning.
Every day, MoneyWeek's executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.
A couple of weeks ago, US president Donald Trump decided the US was going to impose trade tariffs on goods imported from Mexico.
That was a bit of a surprise, as everyone had thought that they had agreed a deal already. But these tariffs were designed to push Mexico to take more action on immigration at the US border.
The 5% tariff was due to go into operation from today.
But on Friday evening – in the nick of time – the day was saved.
Trade Wars – your new reality TV show
Trump has pulled a trade deal out of the hat. On Friday evening, he dropped his plan to charge 5% tariffs on Mexican imports; he said that Mexico had agreed to take “strong measures” to prevent illegal immigration over the US border.
By coincidence, the S&P 500 – the main US stockmarket index – had its best weekly gain this year (up 4.4%).
I’m sure Trump would like to take credit for this. And certainly, investors in other parts of the world will be pleased to realise that Trump isn’t quite as trigger-happy as they might have feared.
However, the rally isn’t about trade. For one thing, there are plenty of suggestions that the deal was in the pipeline for a long time, and that most of it had already been agreed.
As John Authers notes on Bloomberg, Trump has most likely stage-managed it – creating a last-minute crisis on paper and then resolving it, allowing him to look good about doing a deal that had already been done.
And, as Authers adds, markets hadn’t priced in much of a reaction to the tariffs. While a trade war between the US and Mexico would have been damaging (lots of car parts criss-cross the border on their way to the finished product, for example) it’s clear that investors weren’t convinced it would happen.
Instead, last week’s rally was about two main things, both central bank-related. The Federal Reserve, America’s central bank, now appears much more open to cutting interest rates. And that, in turn, takes us to a much more convincing reason for the Friday rally – some very disappointing data on US employment.
Here’s why the market loves bad economic news
On Friday, US non-farm payrolls figures came in much lower than expected. The US added just 75,000 jobs in May. Economists had been betting on 185,000. Worse still, gains in both March and April were revised lower.
Meanwhile, wage growth came in at 3.1% – still beating inflation, but hardly rocketing. The economy might be at near-full employment, but employers still don’t appear to be under a lot of pressure to raise wages to find workers.
You have to bear in mind that the non-farm payrolls data is subject to revision. It’s not a terribly reliable number. It does move markets, but all that shows is that markets are easily moved.
That said, it’s all grist to the “pending recession” story mill. And the more bad news that comes in, the happier markets will be.
Right now, markets want one thing. They want the Fed to cut interest rates or loosen monetary policy one way or another. Investors are starting to think that a July rate cut is a near-certainty.
Is that likely? The Fed, of course, is meant to be independent of markets. But it also operates through expectations management. If the Fed “disappoints”, then you can be sure that markets will react. They want to know where the “Powell put” kicks in, and they will keep testing Jerome Powell, the Fed chairman, until they find his breaking point.
On the one hand, there are increasingly dovish noises from prominent Fed members. As Gavyn Davies highlights in the FT, Fed vice-chair Richard Clarida has noted that he’d be willing to cut rates as insurance. In 1995, the Fed under Alan Greenspan did something similar – cutting rates by 0.75% over eight months. “An economic soft landing followed.”
I get the impression that Powell has no desire to disappoint. However, I’m not sure that he fully grasps that the market likes the Fed to be even more dovish than it expects.
And to beat the current level of hope among investors hungry for looser money, he’d probably have to cut this month, or cut by 0.5% next month. I struggle to see that happening. We might have to see a proper slide in stocks first to trigger the Fed’s panic reaction.
The good news – for investors – is that they don’t have to wait until the Fed acts to get looser policy. As Authers (again) points out on Bloomberg, the US dollar is the “single most important monetary indicator of the moment”.
And measured against a basket of its biggest trading partners, the US dollar fell by 0.5% on Friday. In all, it had its worst week in over a year.
You can already see how this works – the S&P 500 has its best week, even as the dollar has its worst week.
It’s the same for most other markets. The US dollar – as I’ve said many times before – is the most important currency in the world. Almost everyone in financial markets needs it.
If the dollar strengthens, you are making it more expensive to get hold of dollars. Therefore, monetary conditions tighten across the globe. If the dollar weakens, the reverse happens – monetary conditions loosen.
So, all else being equal, a weaker dollar is good for financial assets, while a stronger dollar is bad for them.
The dollar is the indicator to watch right now.
On that note, if you haven’t signed up to watch our webinar tomorrow, then you can do so free now – Dominic and I will be chatting about trade and foreign exchange movements with currency specialist Alex Edwards from OFX. It’s at lunchtime tomorrow – don’t miss it (even if you can’t be there live, sign up to watch it later).