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A Third 2019 Rate Cut Is Here -- But Here's the Fed's X Factor For 2020

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The market got its third interest rate cut of 2019, but it's guidance from the Federal Reserve on 2020 rate policy that most investors are trying to parse.

And it's the U.S.-China trade war that remains the largest unknown, since trade is an incredibly important driver of economic results.

The tariffs the U.S. has slapped on goods imported from China have grown in value from the start of the trade war in March 2018 through Q3 2019. Not only has the economy seen incrementally less demand for goods and services as a result of higher prices due to tariffs, but companies lately have hesitated to increase long-term investments and hiring in the face of an uncertain tariff picture. 

The Fed will have to respond to changing economic data as a result of improving or worsening trade relations. 

The likelihood that the U.S. was going to see its third rate cut for the year was 97%, according to data from CME Group. The yield curve is no longer inverted, with the 10-year treasury yield at 1.84% and the 3-month at 1.63%.

The Fed recently bought short-dated bonds to keep those yields low in an effort to continue stimulating a decelerating economy, moving investors out of longer-dated bonds. Still, the 10-year yield is down from 2.01% since Aug. 1, the day after the market got its second rate cut of the year. 

Now, Fed Chairman Jerome Powell must monitor progress on trade negotiations between the U.S. and China. "It's on Powell to make sure that this trade war stays isolated," Danielle DiMartino Booth, former adviser to the president of the Dallas Fed and Founder of Quill Intelligence, told TheStreet. "If it starts to bleed into services, he's going to have to cut rates further." 

The ISM Manufacturing Index showed activity contracting in August and September from a year earlier, with readings below 50. (Any reading below 50 is a contraction.) But the ISM Non-Manufacturing Index, which measures only services activity (the majority of U.S. economic output), hit 52 in September. While that indicates positive growth, it badly missed estimates of a reading of 55. 

"Jay Powell is going to be looking to see if the industrials recession that we are definitely in bleeds into the services sector," DiMartino said. 

As for services and goods together, "Lower rates are unlikely to spur a sharp rebound in investment, for example, since trade uncertainty has been the main reason for businesses to put off spending," UBS's global chief investment officer for Global Wealth Management, Mark Haefele, said in a note.

President Donald Trump's phase one of a trade agreement between the two sides has recently been seen as more likely to happen than not, although nothing official has been signed. Phase one entails an indefinite hold on Chinese-goods tariffs currently scheduled to go into effect in December.

Still, "A trade deal might not be trusted," Haefele said. "We think President Trump's announcement of a Chinese commitment to buying $40 billion to $50 billion of U.S. agricultural products appears unrealistic." 

Stocks have rallied of late, with the S&P 500 now up 21% year to date, just below its record 3,040.

And while the positives of a fully resolved trade war would outweigh the negatives of fewer rate cuts, investors are still looking for a floor to economic growth, which lower rates provide. 

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