The U.S. Federal Reserve (the Fed) followed through on its July rate cut with another 25 basis-point reduction in its policy rate today. This move was widely anticipated across the gamut of economists and investors. Markets were modestly disappointed today that the Fed did not flag even more rate cuts in its projections for the rest of this year and into 2020, with the S&P 500® Index selling off roughly 0.5% in the minutes following the announcement.
In our view, the Fed’s monetary policy calculus here is actually quite straightforward. There are effectively three interrelated forces that are pushing the Federal Open Market Committee (FOMC) to lower interest rates and—as long as the same constellation of forces holds—the central bank will need to keep lowering rates.
- The China-U.S. trade war has significantly slowed global growth, damaged business confidence and slowed the trajectories of corporate earnings and capital expenditures (capex). Even though the U.S. consumer still looks resilient, downside risks to the economy have intensified. It’s hard to argue the Fed isn’t at or near its full employment mandate when the unemployment rate is hovering near 50-year lows. But remember that the central bank is tasked with keeping it there. Rate cuts should directionally help push back against the downside risks from trade uncertainty.
Inflation expectations are too low for comfort, particularly after a sustained period of inflation undershooting the Fed’s 2% target. Inflation expectations are crucially important to the price formation process. The latest University of Michigan survey showed that consumers’ 5-to-10-year-ahead inflation expectations dipped down to an all-time low in September. And 5-to-10-year-ahead inflation expectations derived from CPI (the Consumer Price Index) swaps are also below levels that would be consistent with the Fed’s 2% inflation target over the medium-term. The Fed is still describing inflationary pressures as muted, and we believe rate cuts can help demonstrate its commitment to achieving price stability.
These two observations warrant an accommodative monetary policy stance, but …
The inverted U.S. Treasury yield curve is telling the Fed its stance may, in fact, be restrictive. I’ll side-step the this time is different narrative here and just quickly say that similar arguments that were made back in 2006 were wrong. Furthermore, many of the models that are commonly used to motivate negative term premia and other distortions to the curve assume that, in equilibrium, rates will normalize back to much higher levels from decades past. We think this assumption is wrong.
Why? The Fed controls short-term interest rates. The market prices long-term rates based on its view of economic fundamentals. While not an explicit or pervasive view on the FOMC itself, we think a case can be made to push the overnight interest rate below the rest of the curve. Based on current pricing, that would still require one more rate cut later this year. We expect that next cut to happen at the next Fed meeting at the end of October. But admittedly, a lot can change in the interim, especially with the outcome of high-level Sino-American trade talks slated for early October unknown.
It’s worth tackling a couple of other headline risks from the week before we shift gears to our preferred interest rate strategy.
The volatility in energy prices does not pose a systemic risk
The drone attack on Saudi Arabia’s oil infrastructure over the weekend was a big surprise both geopolitically and to markets. The price of West Texas Intermediate (WTI) crude oil jumped 15% on Monday. But subsequent news suggests Saudi production is coming back online quickly, and more than half of the spike in WTI has subsequently been unwound.
It’s not unreasonable for investors to be concerned about shocks in energy prices. History is ripe with examples of oil prices causing economic recessions. But context is important here, and even at its peak of 15%, the price increase in oil this week pales from the more systemic episodes historically. For example, oil prices increased 51% subsequent to the Arab-Israeli War in 1973.1 We’re not there yet.
Furthermore, the U.S. economy is much more balanced as it relates to energy exposure than in decades past. The shale revolution has resulted in the U.S. becoming the largest oil producer in the world! The damaging effects of higher energy prices on the American consumer are now partially offset by the boost from higher energy prices onto U.S. energy production and capital expenditures.
The volatility in repo rates does not pose a systemic risk
Money markets have been very volatile over the last 48 hours. This section gets a bit technical, so I will apologize in advance and encourage you to skip ahead if you are not interested in the plumbing of monetary policy.
Simply put, the way central banking works in practice here is that the FOMC decides on the target range for the overnight interest rate. That policy then gets implemented by the Federal Reserve Bank of New York to make sure that overnight interest rates trade within the targeted range. This is done through what are generally called open market operations.
What troubled some investors yesterday was that the effective federal funds rate jumped higher and moved outside of this targeted range (other similar overnight repo rates also jumped higher). We aren’t overly concerned by these developments for two reasons:
- First, the Fed is very serious about injecting enough liquidity to make sure these stresses abate. The Federal Reserve Bank of New York offered reverse repo facilities on Tuesday and Wednesday to alleviate liquidity strains on security dealers.
- Second, the source of the cash squeeze is at least partly transitory in nature. It’s normal for corporate tax payments in September to drain reserves in the banking system. Adding to this, $54 billion in Treasuries settled on Monday.
As these pressures alleviate, and as the Fed does what is necessary to ensure there is ample liquidity in the financial system, we expect these risks to fade. Of course, we will look to rates on non-financial commercial paper and other segments of the money market for broader or lasting signs of strain.
Government bonds still have an important role to play in multi-asset portfolios
This is the longest U.S. economic expansion ever. The inverted yield curve, slowing global growth and downward pressure on corporate profits suggest a cautious approach is warranted at this later stage of the cycle.
While the outlook can turn more positive on a dime if a comprehensive China-U.S. trade deal is secured, the balance of risks suggests some caution is warranted here. Federal funds futures have priced one or two more rate cuts by year-end. We think that pricing is reasonable. If the trade war does sour, it’s possible the U.S. and global economy could falter. In that environment, government bonds may rally further and provide an important diversifying role in multi-asset portfolios.
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