Rate Cut Now, No Promises for Tomorrow

Rate Cut Now, No Promises for Tomorrow

There's reason and room for more rate cuts ahead, but it's unclear if that includes September.


The Federal Reserve (Fed) cut its benchmark interest rates by 25 bps on July 31, 2019, and ended its balance sheet reduction two months ahead of schedule. Both moves were widely anticipated.

Fed Chair Jerome Powell hit a number of dovish notes in his press conference. In the opening remarks he talked about the recovery reaching “low- and middle-income communities” and the importance of sustaining the expansion. Powell said the Fed’s estimates of neutral rates have declined. He repeatedly cited low inflation as one of three reasons for easing policy (his other two reasons were slower global growth and trade tensions). Powell said that future hikes are not “particularly likely, frankly.” Finally, Powell tried to thread the needle by giving the impression that more cuts are possible, while at the same time not over-committing to a large number of cuts: “Let me be clear. I said it's not the beginning of a long series of rate cuts. I didn't say it's just one or anything like that.” Clearly, Powell is leaving the door open for more cuts, consistent with the Fed’s latest dot plot, which had a large number of Federal Open Market Committee (FOMC) participants anticipating two cuts this year.

It wasn’t all dovish, however, as Powell did push back subtly on the assumption that the Fed was locked into cutting in September 2019. The post-meeting statement no longer says the Fed will “closely monitor” developments, but instead only says that the Fed will “continue to monitor” developments. Dropping “closely” suggests a little less urgency than there was in June, and therefore less commitment to cutting at the next meeting. (Powell got dangerously close to suggesting the Fed was done cutting when he characterized yesterday’s move as a “mid-cycle adjustment to policy.” This comment caused 2y yields to briefly rise 11 bps to 1.96%. But, Powell then walked that back later in the press conference with some of the dovish bits cited above, causing 2-year yields to retrace and settle around 1.87%, up only 2 bps on the day.)

So, in summary, my read of the Fed's message is essentially: “Still plenty of reasons to be dovish … probably more cuts to come … but we’re not promising that the next cut will come in September.” That is a somewhat nuanced message, and while Powell struggled at times to convey the gradations, I think that’s a reasonable understanding of the outlook, at least as the committee currently sees it.

The sharpest market reaction on the day was the flattening yield curve; the curve between the 2-year and 10-year was more than 7 bps flatter than at the beginning of the day.. Steepener trades have been popular recently as some analysts were looking for a 50-bp cut, while others are looking for a move higher in yields due to better growth or inflation. The problem with steepeners, however, has been that the Fed pricing in the front of the curve was very aggressive. Powell’s pushback on a September cut made this pricing look even more stretched, which contributed to the flattening. The market has now repriced somewhat, aided by the sharp move on July 31 2019, and as of August 1 2019 there were only 1.5 additional cuts priced in through December 2019. This is slightly above the base case of one more cut, but the mispricing was no longer as extreme as it was a few weeks ago. Stocks were down and the US dollar was up on the day, both consistent with the Fed not being as dovish as market pricing.


Definitions:

One basis point (bps) equals one one-hundredth of one percentage point

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.

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