FOMC: Cutting Interest Rates Again – Third Time’s The Charm?

The Fed will want today’s meeting to be as dull as possible with an expected 25bps cut and the repetition of ‘act as appropriate’ as a nod to future actions. But many questions will linger. Is this the last rate cut? If so, how will they present it? If not, how can they maintain optionality? With no new economic projections to be released at this FOMC meeting, investors will be hanging on every word of the statement and of Chair Powell’s press conference.

FOMC Scenarios: Delivering a Priced-in 25bp Cut with Fingers Crossed

• Base-case: Another Fed meeting, another 25bp rate cut. But the tone of the statement and press conference will be key. By setting up the Treasury reserve management program (buying T-bills via small scale asset purchases) and upsizing the repo operations during the intra-meeting period, this FOMC meeting will probably be more of an update on economic developments and their standing on risk management. If they deem this third rate cut along with all of the new liquidity from repo operations and the ‘not-QE’ T-bill buying to be sufficient to keep financial conditions easy enough into 2020, they risk intimating the end of the rates calibration.

• Dovish-case: Over-delivery is possible, but not our base-case. Many on the FOMC committee may believe much has already been accomplished and that the backdrop looks better, so it’s time to take a ‘wait and see’ approach. If they wanted to act more dovish, Powell could convey that the current repo operations will eventually morph into something more permanent via the introduction of the standing repo facility (ahead of year-end). Coupled with some recent comments from Treasury secretary Mnuchin that GSIBs may see regulatory relief, that would ease market concerns that the recent Fed band-aids are insufficient. This is a tall order even for our most dovish dreams because the Fed wants to avoid suggesting that repo liquidity is open-ended, and logistically it will be difficult to accomplish GSIB relief before year-end.

As much as they will try to make this a non-event meeting, the last two rate cuts resulted in a ‘sell the fact’ outcome, with S&P500 experiencing steep declines (down over 100 points) in the weeks following. Meanwhile, 10-yr rates rallied between 25-50 bps (with the August rally one of largest on record). This time may be different given the easing put in place intra-meeting and stronger recent economic data, however. We assume they are leaning this way and won’t get boxed into more cuts.

All that said, the Fed is slavishly hostage to financial conditions at this point in the economic cycle. Unlike in other cycles, the Fed was quicker to combat the fallout from various uncertainties impacting the US economy and financial markets. However, the multi-trillion-dollar question remains: have they done enough to extend this cycle? Or more pessimistically, will it prevent a recession/market correction?

Future Fed Options: ZIRP, Full-bore QE, L/T Rate Targeting, Buy Credit?

Since September, the NY Fed has upsized its repo operations to address money market rate spikes while keeping ample reserve levels in the financial system. Their repo offerings now sit at $120bn for overnight money and $45bn for 14-day term repos. The Fed also started buying T-bills at a pace of $60bn per month. Fed speakers have emphasised that this is not a version of QE. We disagree; it may not be a version of the old credit easing form of QE, but its QE nonetheless. We still believe the mini-easing cycle is incomplete. We could be entering a period that lulls investors and the Fed into a false sense of security, which could delay further easings for now. The big question is, if more easing is needed, what other options remain for the Fed?

To characterize the state of readiness for Fed easing, we can stylize using the DEFCON system. Based on this scaling, the Fed is currently at a DEFCON-2 (Table 1, below). The Fed may loath to admit it, but they are in easing mode via insurance rate cuts, repo lending, and expanding reserves via QE-lite.

We disagree with comparisons that point to similarities between the Fed’s recent actions and those in 1995-6 when they also cut rates a few times and then paused. Crucially, back in the 1990s, the Fed was not contending with the consequences of quantitative tightening. Today, they are back to buying Treasuries. It may be of a lower duration variety, but they are still buying debt. So while many are fond of the 1990s, perhaps yearning for the good old-days, it is an incommensurable comparison (even if they were to stop at only three rate cuts, which I believe to be unlikely).

Let’s say that after a short period of calm, risk markets come under duress again and that such duress has a negative feedback loop back into the markets. The Fed will not sit around waiting for it to fully unfold like they did in 2008. This may sound flippant, but let’s recall the 180-degree turn they have done this year: they ended the hiking cycle, started easing, and then expanded the balance sheet again. If financial conditions worsen, the Fed will lean into it.

But how? In the table below, we list what the next step – to DEFCON 1 – entails: cutting rates to zero (ZIRP) and re-launching ‘real QE’ again. The Fed would likely buy MBS if weak financial conditions impacted housing (though the hurdle is higher this time). But since the next epicentre of a financial crisis lies in all things credit-related (from BBBs, HY leveraged loans, private credit, etc.), we should expect that at some point the rules will change to allow for real credit easing. And that probably doesn’t matter who is in power. The calls to ‘do something’ will once again overcome the cries of moral hazard.

Table 1: Latest Actions has the Feds on Defcon2 Status (But All is Well?)

Source: Macro Hive

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.

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