July rate cut: Muted inflation allows Fed to provide some insurance. Markets wanted more.
The U.S. Federal Reserve (the Fed) cut interest rates by 25 basis points today, to a target range of 2% to 2.25%—an outcome that was in-line with our forecasts and the consensus of economists. The central bank also terminated its quantitative tightening (QT) program two months ahead of schedule to ensure its interest rate and balance sheet policies were not working at odds with one another.
No surprises behind quarter-percentage point cut
Today’s shift toward a more accommodative monetary policy mix was well telegraphed. The Fed leadership is going dovish to push back against policy uncertainty from the trade war, weak business investment and weak economic activity abroad. Typically, this late in the cycle the Fed needs to balance the benefits of a rate cut with the costs. Namely, late-cycle cuts normally risk an overheating of inflation and asset bubbles. But today, with inflation undershooting the Fed’s target and with market-based inflation expectations below what would be consistent with the Fed’s 2% inflation target, more price pressures would actually be welcome. That makes the to cut or not to cut calculus MUCH easier.
3 reasons why another rate cut in September appears likely
We ultimately think the Fed will deliver another 25-basis point rate cut at its next meeting on September 18. Supporting this are three main reasons:
- The Fed, in its guidance over the last month, has expressed a desire to have an accommodative monetary policy stance. And yet—even after today’s rate cut—the target range for the federal funds rate (2% to 2.25%) remains modestly above the 10-year U.S. Treasury yield (2%). Put differently, the inversion of the Treasury yield curve is a signal from the market that Fed policy may still be restrictive.
- The recent trade talks in Shanghai did not result in a deal or any observable progress, and the next high-level China-U.S. talks are not scheduled to take place until September. This means the uncertainty from trade policy will remain a persistent headwind on the global cycle into the September Federal Open Market Committee (FOMC) meeting. We expect capital expenditures and the global industrial cycle to remain weak against this backdrop.
- The Fed is still providing the same guidance AFTER today’s rate cut: that uncertainties remain and that it “will act as appropriate to sustain the expansion”. If today’s rate cut was a one-and-done decision, we would have looked for a more balanced characterization of the risk to the outlook post-cut.
What’s behind the poor market reaction?
Markets were disappointed today. It’s hard to ascribe that disappointment to anything specifically that Fed Chairman Jerome Powell did or did not say—his tone was clearly dovish. Rather, the downward movement in stocks looks like a more natural recalibration, as markets had gone a long way in extrapolating rate cuts from the Fed. And Powell, in the ensuing press conference, was measured. In our view, this makes the Fed’s September monetary policy decision a bigger event risk to markets.
Presuming we are right—and the Fed follows through with another rate cut in September—the focus will then likely shift quickly to the dot plot and forward guidance. If, at that time, the dot plot signals that the Fed thinks it’s done with this mini-cycle of insurance rate cuts, that would likely prove hawkish relative to market pricing (which is still looking for more). It’s also important to emphasize that the notion of insurance cuts can only be extended so far. For the Fed to deliver a sustained easing cycle, it would need to grow much more worried about an imminent recession—an outcome that would not be good for risk markets either.
Our tactical investment strategy has been and still is to err slightly cautious here. Credit and equity market valuations are expensive. We see modest downside risk to cyclical fundamentals—the manufacturing sector is weak, the S&P 500® Index is flirting with a mild earnings recession and earnings revisions are negative. But at least for now, the strength of the labor market and consumer are pushing back against larger downside risks. Finally, investor sentiment—which we look at to identify tactical behavioral dislocations in markets—appears neither euphoric nor panicked at the moment.The biggest upside risk to our outlook would be an earlier than expected resolution to the trade war. A removal of policy uncertainty could drive a re-acceleration in U.S. and global growth (a la 2016). And, given inflationary pressures remain muted, we don’t think the Fed would immediately respond to that strength with rate hikes.