While we await the Fed’s interest rate decision later today (2pm ET), the first estimate of third quarter GDP was released and the results noted in the report will surely be a part of the Fed’s deliberations. GDP slowed to 1.9% versus 2.0% in the second quarter but the result beat the 1.6% expectation. Once again, the consumer carried the load with personal spending growing at a 2.9% pace which was off from the torrid 4.6% rate in the spring but better than the 2.6% expectation. Forecasts for fourth quarter GDP are for further slowing to 1.7%, per Bloomberg consensus. If the forecast is met, that would imply a full-year GDP rate of 2.1%, matching the Fed’s latest estimate but well off the 2.9% growth logged in 2018. Full-year 2020 GDP forecasts are for further slowing to 1.7%. While stocks climb to record highs, and some of the geo-political uncertainties recede, combined with the modest growth picture it allows the Fed to pause after today’s cut, but they’ll be poised to cut again should the economic picture deteriorate more than is currently expected. At the moment, Treasury prices are little changed, however, as the market awaits the Fed’s rate decision and forward guidance (more on that below).
With the Fed decision coming at 2pm ET, let’s take a look at some of the things we expect to see:
- First, and coming as no surprise to anyone, we think the Fed cuts 25bps and it’s likely to come with the same two dissents as the July and September cuts: Boston Fed President Eric Rosengren and Kansas City Fed President Esther George. While St. Louis Fed President James Bullard was a third dissenter in September, he was at the other end, he thought the Fed should have cut 50bps. It’s not likely he dissents again today, but another hawkish type could add a dissent to Rosengren and George. A third hawkish dissent would put additional pressure on Powell if plans were afoot for a December cut.
- Second, we think the statement will include language implying that a period of pause is on us again, so expect odds of a fourth cut to diminish again. With no updated dot plots at this meeting, the statement and press conference are the only two vehicles providing the market with the forward guidance to assess the possibilities of a rate cut before year-end and/or the number of cuts in 2020. With today’s positive GDP surprise a clearly stated pause in rate cuts becomes a more likely scenario.
- Third, since the September meeting and rate cut the market has adjusted its outlook such that fed funds futures are no longer pricing much odds of another cut in December and have priced in just one 25bps cut in 2020. With a Fed sitting with limited ammunition to fight a slowdown, they are likely to run with market’s rate-cutting outlook and do little to dissuade investors to the contrary. Thus, while some knee-jerk market volatility always prevails on Fed Day, we don’t expect big moves that persist given how close the market is to Fed expectations.
- Fourth, that being said, and given the modest slowing in GDP growth, the Fed, and Powell in particular, have been adamant about doing what they can to keep the expansion on track. Thus, despite the likelihood of a patient pause coming out of today’s meeting, if the slowdown were to gather momentum to the downside, rest assured the Fed would be back in the rate-cutting game.
Our view is that after the rate cut today, the Fed will want to see how the 75bps in cumulative cuts are working through the economy, that means they would love to sit out a December cut. One area that has shown a decided rebound from the three rate cuts has been housing with lower mortgage rates a big contributor to that rebound. The problem is housing is not a huge part of the GDP pie so it will have only modest impact to GDP growth. The better-than-expected third quarter GDP growth gives the Fed some room to pause, but that being said, they won’t stray too far from the rate-cutting button if the slowing growth deteriorates faster than is currently expected.
While fourth quarter is typically a seasonally bearish period for Treasuries, and October certainly lived up to that reputation, once the calendar turns to 2020 we think the limited back-up in yields will prove too attractive, especially when investors reacquaint themselves with the slowing growth expectations for 2020. Thus, while the Fed may move to a patient pause stance today, we think investors too should be patient to wait out the bearish impulses this quarter and look for better yields and entry points in early 2020.
30yr MBS Yield Spread to Treasuries at Multi-Year Highs
While 10yr Treasury yields have backed-up approximately 33bps during October, MBS yields have faired even worse as the graph illustrates. When looking at 30yr MBS spreads to a blend of 10yr and 5yr Treasuries the spread at 104bps is near the highs last seen in 2016. Many of our clients have been active investors in this space taking advantage of both higher yields and wider spreads. This pattern could continue through the fourth quarter as Treasuries typically come under pressure as year-end approaches. When the calendar turns, however, these yields and spreads are likely to reverse to some extent.
Agency Indications — FNMA / FHLMC Callable Rates
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