Financial markets provided the Fed with a lesson on expectations.
U.S. Rates vs. the Market: Resistance is Futile
The Fed’s Jan. 30 statements retreating from previous positions on rate hikes was welcomed by financial markets. However, that kind of market-driven comeuppance is often a hallmark of a new Fed Chair's term, notes Brandywine Global’s Francis Scotland in A Trip to the Woodshed, who also observes that Chair Powell's FOMC may be newly reluctant to raise rates over the following six months: “The Fed Chair is to be commended for reversing course as decisively as he did. But it is also human not to want to be humiliated again, especially anytime soon.”. Given this changed reality, the newly dovish Fed faces a new issue whether financial markets have sufficient liquidity to support continued economic expansion: “The U.S. monetary base is still contracting, and growing U.S. fiscal deficits reduce the supply of dollar liquidity available to the rest of the world”. The same holds true for the Fed's planned reduction of its own balance sheet. Given that dynamic, there could be increased pressure either to slow the sale of assets, or even to cut the target rate.
Indeed, the current Fed Funds target rate of 2.50% might no longer represent a neutral monetary stance. That rate is currently converging on the yield for 5-year Treasuries – something that has preceded pro-growth Fed rate cuts in the past.
Could a rate cut be possible this year?
Chart courtesy of Brandywine Global. Source: Bloomberg, as of Feb 8, 2019. Note: The Fed Funds rate used in the chart is the upper-target; since 2008 the target "fed funds" level was replaced by a target range. 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.
On the rise: U.S. Government Debt Outstanding
As of Feb 11, the Treasury Department calculated the total public debt outstanding to be $22.013 trillion, of which $16.2 trillion was listed as debt held by the public. The remaining $5.8 trillion was described as "intragovernmental holdings", presumably bonds held by other agencies. In terms of cash flow, the government has issued $2.464 billion of individual and $0.309 billion of business tax refunds so far.
This politically-charged figure for total indebtedness is different from the U.S. budget deficit, which is more difficult to measure, and is calculated as the difference between government revenues and expenditures over a given interval. The Treasury Department's most recent figure, as of November 2018, was a deficit of some -$204.9 billion.
Finger-pointing notwithstanding, many observers credit the increase in government spending for 2018's strong economic growth. The question, for some, is how the debt, as well as the deficit, might become entangled in the fraught political environment ahead of the Congressional and Presidential elections of 2020.
On the slide: Euro vs. U.S. Dollar
Down from its January 31 high of $1.1513 per euro, the 19-country common currency fell to as low as $1.1266 on Feb 12 before rebounding slightly. The downbeat economic news out of Europe has contributed, with Italy's GDP falling for the second quarter in a row and Germany narrowly managing to avoid recession.
But a major contributor to the drop may have been renewed optimism about the prospects for U.S. growth in the wake of the January 30 Fed decision to leave rates unchanged, and to adopt a distinctly more dovish tone. The downward move of the euro serves as a timely reminder that interest rate differentials are only one of many factors playing into exchange rate movements; conventional wisdom might have suggested that the change in rate outlook for the U.S. would drive the dollar lower.
All data Source: Bloomberg as of February 12, 2018 unless otherwise specified.
The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed) 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 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.