Today’s Federal Open Market Committee (FOMC) meeting was decisively and deliberately dovish. This was about as far as the U.S. Federal Reserve (the Fed) could have gone without actually cutting interest rates at the meeting’s conclusion.
In the statement accompanying the meeting, the committee made a number of changes, including:
- Downgrading the characterization of growth from solid to moderate
- Noting business fixed investment is soft
- Stating that inflation expectations have declined
- Perhaps most importantly, noting that uncertainties have increased
Fed Chair Jerome Powell also prominently flagged these downside risks in the ensuing press conference. Ultimately, the FOMC found it best to watch carefully and wait for more data before slashing borrowing costs. Markets rallied in the minutes following the central bank’s stand-pat decision, which held interest rates steady at a range of 2.25% to 2.50%, with the S&P 500® Index up 0.3% and Treasury yields declining across the curve.
To cut or not to cut: the Fed’s calculus
The Fed ultimately considers a cost-benefit analysis in its policy decisions.
Normally, late in the economic cycle, the cost of a rate cut is that it risks an inflationary overheating and financial instability (asset bubbles). However, those standard considerations are not particularly troubling at the moment. On the inflation front, subdued core inflation, coupled with eroding market- and consumer-based measures of inflation expectations—which are currently moving below the Fed’s 2% target—means the Fed would actually welcome more inflation right now.
The benefit of a rate cut is clear. By providing more accommodation, the Fed can:
- Cushion against the slowing it sees in the global business cycle
- Buffer against the uncertainties pummeling the U.S. corporate sector from the trade war with China
- And, all else equal, un-invert the U.S. Treasury yield curve and help the central bank gain more confidence that its policy stance is actually somewhere between neutraland slightly accommodative
In a nutshell, the inversion of the yield curve right now is telling the Fed that its current policy stance may actually be restrictive, and so two rate cuts would likely be sufficient—all else equal—to un-invert the curve. Finally, given the proximity of current policy rates (2.4%) to the zero lower bound (which occurs when the short-term nominal interest rate is at or near zero), policymakers know that it’s important to respond quickly and forcefully to any downside risks as they emerge—basically to make the most of the nine bullets they have left.
We expect the business cycle to continue to decelerate until a trade deal is reached with China that removes the uncertainty for CEOs on a global scale. With inflation currently muted and with a likelihood that U.S. economic data will remain lackluster in the very near-term, we think the Fed will cut interest rates in July and September by a cumulative 50 basis points. We’d note, however, that there is a wide uncertainty band around this baseline forecast.
We’re at a fork in the road for the U.S. outlook. If a trade deal with China is reached promptly at the G20 meeting or shortly thereafter, we think the combination of lower interest rates, Chinese stimulus and diminished uncertainty could stoke a positive mini-cycle and lift risk assets. In this environment, the Fed may not cut at all and 10-year Treasury yields would likely rise back up to 2.75% or higher.
If the U.S. administration continues its campaign of maximum pressure, risks of a U.S. and global recession by year-end cannot be completely ignored. Our Business Cycle Index (BCI) model is currently flagging a 32% probability of a U.S. recession in the next twelve months. The inversion of the Treasury yield curve is particularly troubling given its historical efficacy in predicting economic downturns. And some high frequency data, like the Empire State Manufacturing survey, have slowed abruptly following the escalation of tariffs with China in early May.
Of these two scenarios, we think the more optimistic case is more likely. The political calculus for President Trump should push him toward trying to ensure a strong economy for 2020. But we are very humble about our ability to forecast the decisions from the U.S. administration over the next few months. And we see the risk to markets, given that we are late in the cycle and valuations are expensive, as skewed asymmetrically to the downside. Ultimately, this bifurcated outlook leaves us with low conviction on the tactical opportunity set. Instead, we’d emphasize the importance today of sticking to a long-term strategic plan, as well as recognizing the critical role that a properly diversified multi-asset portfolio can play during times of elevated uncertainty, such as today’s.
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