July 08, 2019
Next week markets will be watching for the minutes of the Federal Reserve’s June 19th meeting, at which it opened the door to an easing cycle. The big question is now whether it will walk through the door and cut the policy rate at its meeting on 30-31st July, leading to lower rates for longer.
The minutes, due to be released on Wednesday, will give a behind-the-scenes account of the discussions. In dissecting every detail, investors will seek to find more clues as to whether a cut is to be, or not to be, in order that they can position themselves ahead of the July meeting. Will the Fed step in to prolong what has become the longest expansion since 1854?
The June dot-plot (a diagram revealing Fed officials’ projections for appropriate interest rate levels for the future) suggested that the Fed would keep rates on hold until 2020, when a cut is pencilled in. However, this could quite easily change, as 8 out of 17 Fed officials foresaw a cut in 2019 meaning that it will take only one policymaker to shift the balance in favour of a 2019 cut. Fixed income markets have been pricing in 3 cuts in 2019 and a further cut in 2020. They see a rate cut at the July meeting as a done deal with close to 100% probability.
The big question is whether the Fed will acquiesce…
Some may say that such dovishness is not warranted following, the G20 Summit in Osaka, where the US and China agreed to resume dialogue, diminishing the risk of an imminent, full-blown trade war. However, proponents of a cut argue that the positive outcome on trade takes little pressure off the Fed. Nothing tangible has yet been decided, and as we seen last November when we were almost on the brink of a deal, discussions can briskly breakdown. Allianz Chief Economist, Mohamed El-Erian writes: “Over the longer-term, translating a ceasefire into a durable trade peace is far from automatic.” Indeed, Treasury markets barely registered the truce.
Furthermore, though the Fed must assert its autonomy, it is by no means an island, and is undoubtedly cognizant that it would rattle financial markets (and President Trump) if it did not act in July. We will look to the minutes for further illumination on this point.
The Fed has also expressed desire to do what is needed to prolong the expansion and Chairman Powell himself has said that ‘an ounce of prevention is worth a pound of cure’. This lays the path for a ‘pre-emptive cut’, in order to keep the economy sailing along. In doing so, the Fed may prevent weak spots in US macro data from worsening, especially with regard to job gains and sentiment. Justification could also come from the fact that inflation expectations do not foresee price pressures aligning with the Fed’s 2% target anytime soon. So, while an economy with expected GDP growth of 2.5% for 2019, improving investment and high consumer spending may not look in need of a rate cut, perhaps that’s not the point. The Fed wants to act before thing start to turn pear-shaped. The Fed has recently expanded its gaze beyond the US and globally speaking, manufacturing PMIs are not pretty and trade is still dented from the US-China spat.
For now, our view is that the Fed will go ahead with a cut in July to allow the cycle to continue ageing gracefully. And it won’t be on single player mode. The ECB also paved the way for further easing at its June meeting and the Reserve Bank of Australia has already cut rates to a historic low of 1%.
Of course nothing is certain, but it certainly appears that the Fed is about to give Wall Street what it wants…
Longer term, it seems that investors will have to grow accustomed to a lower rate environment. This will probably mean that in order to achieve the same level of returns that they have been used to achieving in the past, investors may need to add more risk. In doing so, it becomes crucial to fully comprehend the risk (for example, default risk or the impact that sudden herding out of risk assets could have at the lower-end of the quality spectrum if markets get nervous…) and to protect one’s portfolio using diversification and a rigorous asst selection process.
Author: Group Investment Office