Fed Needs 50bps Cut For Impact (3 min read)
A combination of disappointing US jobs and inflation data, dovish Fed comments, and concerns over trade deals has brought Fed rate cut expectations into upcoming FOMC meetings. The next meeting in June has a small probability of rate cut priced-in, and many are now looking for a Fed cut in the July meeting. Markets, it seems, have flipped the old saying of “don’t fight the Fed” to “don’t expect the Fed to fight”.
This may be premature. Yes, the Fed’s next move will be a cut, thus ending its hiking phase, but at this juncture, the hurdle is still high for cuts in the next few months. The Fed requires more data and/or a complete breakdown of the US/China trade talks after the G20 summit (which takes place after the June FOMC meeting) before cutting rates. In addition, the Fed has a trick up its sleeve: its balance sheet will stop shrinking (i.e. QT is ending) and it will return to QE-like bond buying after the summer.
Moreover, looking back at 10yr US rates movements around major Fed QE-like announcements, and comparing those periods to how rates reacted both into and out of the first rate cut of a new easing cycle, I found the following:
- It’s clear that QEs are losing their effectiveness over time (see charts)
- A series of large rate cuts will be more impactful
- Unless the Fed cuts like it did in 2007, US Treasuries will stop rallying
In my opinion, to gain maximum effectiveness, it makes more sense for the Fed to do a big cut in September, rather than before. Therefore, in terms of paths over the summer months, here are two likely ones:
Path one – eventual big rate cuts
My base-case is that the Fed will cut rates, but not so soon and not by 25 bp. There will come a time when financial conditions tighten sharply, possibly through much lower stocks and wider spreads. In such a case, they would need to drop the hammer with chunky 50 bp cuts between now and early 2020. Recall that in early 2008, in a period where stocks were nosediving (down quickly and by -10% to -15%), the Fed cut rates by a large 75 bp on 22 January ahead of a scheduled meeting (at which it cut another 50 bp on top of that).
The cuts priced by markets are not factoring in this scenario for the coming months. If they were, expectations would have gone over 100% priced-in for the meetings. For markets to get this point, we would need to see trade negotiations take a turn for the worse while data softens further.
The more likely path in the upcoming meetings is for Fed chair Jerome Powell to sound dovish, but avoid getting boxed in on the timing of cuts. The FOMC can also use forward guidance (in the form of lower dots) and possibly signal that rate cuts could be in larger increments than 25 bps. This could be enough to keep markets reassured that the Fed has got their back. This path would also have the bonus of demonstrating the value of Fed independence.
Path two – Fed cuts rates, nice and slow:
After years of seeing glacial Fed hikes at 25 bp a clip, maybe the market is right about the magnitude of cuts and the Fed delivers a series of them instead of waiting and reacting to the results of each. The trouble with this scenario is that it is already priced-in. This means that there really isn’t a Fed trade left to do and I don’t see value in US Treasuries in this scenario.
So with 10yr US Treasuries down over 100 bp since the 2018 highs, yields under the target rate, term premia near the lows, and QE unlikely to be as effective as next time, it’s prudent for the Fed to guide markets off the edge and save its policy rate cutting ammo for the right time. This means some scaling back of rate cut expectations for upcoming meetings, but preparing for bigger rate cut increments later in the year.
US Bond Yields Around QE Announcements
US Bond Yields Around Fed Cut Events
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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