The FOMC rate decision is mere hours away (2pm ET), and the first rate cut in a decade is upon us. The expectation here is that the Fed will deliver a 25bps cut while the parlor room betting revolves around whether Powell and Company can yet again out-dove the market. Recall that every meeting since December the Fed has managed to deliver some type of dovish surprise despite the market expecting a fairly dovish Fed. Whether it was an early pause to rate hikes, an early halt to balance sheet run-off, or the recent shift from patient pause to imminent easing the Fed has managed to out-dove the market and that led to stock rallies and rallies on the shorter end of the Treasury curve as investors positioned for coming rate cuts. As to whether we think the Fed will pull a dove out of the hat yet again, and what that might involve, read on below. In addition, we’ll be back later this afternoon with a synopsis of the Fed’s actual rate decision and forward guidance.
As mentioned above, we think the Fed delivers a 25bps rate cut later today. While that in and of itself is not a big surprise there is reason to suspect they will continue to try and out-dove the already dovish expectations that are in the market. Recall the market is expecting approximately 62bps of rate cuts through December based on fed funds futures pricing so a 25bps rate cut followed by a one-and-done type pronouncement would disappoint the market, but that’s not what we’re expecting.
The recent spate of better-than-expected economic releases, headlined by second quarter GDP beating expectations at 2.1%, dashed most hopes for a 50bps rate cut, so one way for the Fed to out-dove the market is probably off the table. What we think they do beyond a 25bps rate cut is to make clear that with cross-currents still buffeting the global economic outlook, and with inflation remaining docile, the door will be open to further rate cuts this year. Unless inflation readings surge and uncertainties like Brexit and trade-related issues are suddenly solved, a September rate cut seems likely and a December cut could also follow if the aforementioned issues remain unresolved. From a messaging perspective it makes sense too that they suspend balance sheet run-off now versus the previously announced September date. If you’re cutting rates why still engage in the modest tightening that balance sheet run-off engenders? Ending it now avoids those uncomfortable press conference questions.
On the inflation front the news remains disappointing to a Fed expecting various “transitory” factors to recede allowing inflation to move to, and perhaps above, the 2% target. Yesterday’s release of the June personal income and spending numbers contained the Fed’s preferred inflation metric, core PCE, and while the results were part of second quarter GDP the June numbers provide the most current look at the inflation trend and core PCE missed expectations at 1.6% year-over-year versus the 1.7% forecast. Meanwhile, May was revised down from 1.6% to 1.5% making it the third straight month at that level.
The read on inflation gives the Fed the an opening to follow the expected 25bps rate cut today with another one in September, again absent a sudden improvement in global uncertainties. In that regard, new U.K. Prime Minister Boris Johnson has so far not backed off his statement that the U.K. will leave the E.U. by October 31, with our without an agreement, and has hinted he may skip talks with the E.U. For his part President Trump was busy tweeting yesterday about the sorry state of China’s economy and that they are desperate to make a deal so a sudden breakthrough in those negotiations seems unlikely too.
So the Fed is left with a domestic economy that is still performing well by most measures, but they are also confronting a global economy that is sputtering enough to force most other central banks into rate-cutting mode, or at least considering such moves. As the Fed deals with that dichotomy foreign currency markets are already on the scent sending global currencies another leg lower versus the dollar, and if left unaddressed that will present headwinds for the economy and the Fed.
A stronger dollar makes our exports more expensive to overseas buyers and at the same time makes imports cheaper. Cheaper imports put downward pressure on inflation, especially for an economy that annually buys nearly $600 billion more in imports than it sells in exports. The inflation pressure, however, is only half the story. The other half is that a stronger dollar encourages import buying versus more expensive domestic goods and that has negative GDP implications.
Thus, as long as the rest of the world is engaged in rate-cutting in some form or fashion the Fed will be hard-pressed not to join the party. That’s why we think the rate cut today will be followed by more. Whether that’s two or three cuts this year is beside the point which is that after a decade the Fed will once again be in easing mode and it’s likely to be a lengthy affair. Short maturities will take their clues from the Fed, and if the rate-cutting follows the same pattern as the rate-hiking expect the futures market to price in 50bps of rate cuts in their rolling six-month forecasts. Longer-term maturities are probably susceptible if the Fed looks intent on sticking to the rate-cutting regime. That higher rate range, however, is probably limited. The Fed’s most recent forecast of 2.50% for longer-run fed funds is probably a solid support level for any back-up in 10-year yields. On the other hand, disappointing growth and/or inflation news will put 1-handle 10-year yields in play.
Strong Dollar will Bedevil the Fed
As the Fed grapples with the reality of a domestic economy that seems to be hitting on most cylinders they are also cognizant that uncertainties and weakening growth trends abound overseas. With most central banks either commencing with rate-cutting, or considering it, those policy moves combined with global uncertainties have contributed to dollar strength. Even if the Fed wanted to be one-and-done with rate cuts given solid domestic results, persistent dollar strength argues against that position. The disinflationary impact of a strong dollar, along with the trade headwinds it creates, makes that position untenable. So, keep an eye on the dollar as one guide to future Fed moves.
Agency Indications — FNMA / FHLMC Callable Rates
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