The Fed’s Shooting Star: An Insurance Cut or the Start of an Easing Cycle? (4 min read)

In the US, July will conclude with a series of potentially spectacular meteor showers and, perhaps more eye catching, the first Fed rate cut since the 2007-2008 easing cycle. For investors, there are three important questions. Will it be a 25bp or 50bp cut? Will they portray their move as an insurance cut, or hint that further cuts are in store? And finally, what else could the FOMC say to deliver a dovish-tilted message?

 

The Backdrop

Although for quite some time bond markets have been pricing in anticipated cuts at the upcoming meeting, a rate cut is a special event and tends to occur only at key inflection points.

For one, a Fed ease when the major US equity indices are near all-time highs is relatively unique. Although a large segment of second tier data suggests global weakness is starting to seep in – and that, along with the impact from the trade wars, is slowing US growth – there has been some solid data releases as of late on the labour front, as well as a solid retail sales report.

The economic argument for easing is that the Fed has failed to consistently hit its inflation target. This, though, is a weak argument because that failure has occurred even when they were hiking. Chair Powell also views rate cuts as a way to ‘sustain the expansion’ and as a tool to offset future economic uncertainty.

Market participants, however, are in reality banking on the notion that the Fed does not typically disappoint once rate cuts are fully priced in. This last point is probably more important for stocks than bonds at this juncture.

 

The Next Moves

Those of you who have been trading only over the last ten years, when the Fed was on hold for seven years followed by a three year period of glacially raising rates, prepare for a fast paced environment if the Fed does kick off an easing cycle. Historically, the Fed cuts at a much faster pace and at times by larger clips versus rate hikes. There is plenty of potential for shooting stars. My base case would be the following:

  • The Fed will cut rates by 25bps at its July meeting. In the press conference Chair Powell would signal that more cuts are likely until they see data turn and inflation improve (a fair assurance that they will cut another 25bps in September).
  • The Fed could also try to appease markets that are yearning for a 50bps cut by finally ending quantitative tightening (QT) instead. So, there is a risk that the balance sheet contraction ends sooner, pulled forward to August. Ending QT this soon comes with challenges. Is the NY Fed desk prepared? And where will they reinvest? The answer to this last question is an important one if the Fed’s easing goal is to re-steepen the curve.
  • There could also be questions over when to launch a Standing Repo Facility (SRF). The SRF tool should help tighten overnight rates, smooth out repo volatility and quarter-end spikes.

However, I can’t rule out a more dovish scenario, which could unfold like this:

  • The Fed’s communication has been erratic of late, so their apparent guidance for a 25bps cut may have been misinterpreted and they end up cutting 50bps.
  • If they do this they can probably keep the QT conclusion as planned for late September/early October.
  • With a 50bps cut, the press conference will be that much more important. If it is portrayed as ‘the Fed wanted to get out ahead of the uncertainty but will stay with a wait-and-see mentality’, that would be deemed as more of a one-time insurance ease.
  • Chair Powell could temper any fallout from such a scenario by emphasizing that they stand ready to provide more liquidity ahead. In this scenario nothing is stopping Powell from mentioning the SRF too.

I think there is a 60% or greater chance that my base-case scenario comes to fruition with the balance falling into the dovish-case. I completely omit the risk that the Fed overtly fails to deliver. This Fed meeting will be all about shades of grey on how dovish they want to be. They will cut 25bps and if I’m wrong it’s going to be because they end up being more dovish.

 

Some Technical Considerations

In many ways, the Fed has been tweaking policy rates already to address technical issues in the money markets over the past year. Given how repo and Fed effective rates have been less receptive to the 5bp tweaks of the IOER, policymakers will watch keenly to see if a blunt 25bp cut will help nudge the whole US money market complex in kind. In many ways, the ending of QT and potentially highlighting the benefits of launching an SRF could work better at changing money market dynamics and sentiment.

The recent passage of the debt ceiling also complicates the Fed’s outlook. If the Treasury takes a slow approach at rebuilding its cash position, that could give the Fed cover to ease at a 25bp per meeting clip. Although the Fed wants to ‘soft land’ the economy and undo some of their 2018 rate hikes, if this first ease fails to satisfy markets and dollars remain in demand throughout 2H19, the Fed will need to ease more aggressively to counteract the tightening of US funding markets that may occur as T-bill supply ramps up.

 

George Goncalves is a twenty-year veteran of fixed income markets. Over that time, he has covered rates, structured products and credit, working 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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