The Fed: Insurance rate cut, or something more?

Mid Week Bond Update

The Fed: Insurance rate cut, or something more?

Does today's economic backdrop justify rapidly repeating rate reductions? Or will a “just in case” rate cut do the trick?


An unusual amount of clamor surrounds the consensus view that the FOMC will cut its target rate at the conclusion of its July 30-31, 2019 meeting. In speeches official and otherwise, Fed governors, including Chair Jerome Powell, have clearly expressed the view that a reduction in the Fed Funds target rate is warranted at this time; their views mostly vary about what could come next, and when.

But it’s worth noting that several generally respected measures of financial conditions show an economy in better shape than the inverted sections of the U.S. yield curve appear to imply.
 

National Financial Conditions: Solid Reading from the Chicago Fed

Chart courtesy of Brandywine Global.  Source: Chicago Fed via Bloomberg, as of July 23, 2019.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
 

The Chicago Fed’s National Financial Conditions Index measures credit, leverage and risk, based on a wide variety of inputs, and is updated weekly, comparing current conditions to a longer-term average. While the index is solidly in the “loosening” range, this measure doesn’t clearly capture future financial stressors – including recessions. Recent research by Brandywine Global suggests that current financial conditions are consistent with slightly lower growth than the current U.S. rate, but that present levels of financial stress aren’t sufficient to clearly generate continuously deteriorating growth.  In short, the data are consistent with a normal mid-expansion slowdown – if “normal” includes one of the longest stretches of growth on record. And said slowdown could easily be enough to justify a “just in case” rate cut to keep things going – even in the face of the recently renewed bout of fiscal stimulus seemingly on its way from Washington.
 

On the rise: U.S. 5-Year Breakeven Inflation

Three closely followed measures of market-based inflation expectations for the next five years continued the generally upward move started in mid-June of this year (2019).  Most notably, the 5-year / 5-year breakeven inflation rate, based on the differential between 5-year Treasuries and their inflation-adjusted equivalent have risen above the 2% Fed inflation target level for the first time since April of this year. The Fed’s own breakeven rate, which was last updated on July 12, 2019, has also been heading upward, reading 1.852% at that date.

Because these measures are based upon rapidly moving market prices and rapidly changing expectations, they reflect little more than today’s expectations and can’t be relied upon in any meaningful sense as predictions.

But as measures of the current mood, they appear to have captured the strong consensus that a Fed rate cut is imminent, and that the cut, as well as the ones that could follow, might succeed in boosting inflation at long last.
 

On the slide: The British Pound vs. the U.S. Dollar

Sterling has been having a tough time of it compared to the greenback. Since May 3, 2019, the currency has dropped some 5.7% against the dollar. Surprisingly, that’s not solely attributable to the dollar; over the same interval, the U.S. Dollar Index is down about -0.12% vs. its standard basket of currencies.  It’s an oversimplification to lay blame solely at the feet of Tory Prime Minister Boris Johnson. But the uncertainty surrounding the terms of the October 31, 2019 separation from the European Union is unlikely to fall as the new Tory leader takes charge.


All data Source: Bloomberg as of July 23, 2019 unless otherwise specified.

Definitions:

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.

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 funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

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.

U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

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

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.

The 5-year, 5-year forward breakeven inflation rate is a measure of expected inflation derived from "nominal" Treasury securities and their "real" counterparts—inflation-protected TIPS securities.

An implied breakeven rate is a measure derived from comparing returns of two classes of securities whose value depends on the same factor, such as inflation or default rates.

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

The DXY U.S. Dollar Index measures the value of the U.S. dollar relative to the exchange rates of six major world currencies (the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc) which represent a majority of its most significant trading partners.

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