Dovish enough? Here’s why the Fed’s rate cut could leave investors disappointed.
All data as of July 23, 2019.
For the first time in 10 years, the FOMC is widely expected to cut the Fed funds rate 25 bps this Wednesday to 2.00%–2.25%. While markets have welcomed the shift toward easier monetary policy, the outcome of the upcoming Fed meeting will be more nuanced than the headline rate move. Investors may need to brace for heightened volatility given current rate cut expectations – beyond the good news of a rate cut, markets may end the week disappointed.
Cut little or cut big?
Markets are widely expecting the Fed to announce a 25 bps rate cut to 2.00%–2.25% on Wednesday at 2 PM, the first rate cut in 10 years. The Fed’s pivot over the last several quarters from forecasting tighter monetary policy – which acts as a brake on the economy – to easier monetary policy has been received positively by markets. Indeed, in their exuberance, markets have priced between two and three rate cuts by the end of 2019, about 65 bps of easing.1
For the July 31 meeting, there had been speculation that the Fed could cut 50 bps, and some of these expectations linger. Currently, about 1 in 5 market participants are looking for the more aggressive half-point move. Disappointment over a smaller than expected rate cut could translate into volatility following the meeting.
These more exuberant rate expectations extend beyond this week’s meeting. Communication from the Fed has, at best, been confusing and, at worst, simply mistaken. Two weeks ago, two dovish speeches caused market expectations of a 50 bps rate cut to surge to 66% and the 3-month Treasury bill yield to plunge to a 13-month low, which led to the unusual step of the New York Fed publishing a follow-up statement “clarifying” its president’s comments. Muddled Fed communications could continue to inject volatility into financial markets.
Markets must contend with more than just the interest rate adjustment on Wednesday. The FOMC statement will include important language with guidance on the Fed’s appetite for future rate moves. On the hawkish to dovish spectrum of outcomes (higher to lower policy rates), there are several nuanced outcomes likely around a quarter point cut.
Our table offers a general guide to the FOMC, but in truth there is a wide range of outcomes, any one of which could ignite market jitters given how far the pendulum has swung in the dovish direction. Indeed, given the relatively upbeat tone of the U.S. economic data and the fact that policy rates are already so low, we expect the Fed to pivot to a more data-dependent posture. Markets, however, are positioned for a dovish cut given that, after Wednesday, about two more rate cuts are priced in through the remainder of the year. We think markets may be headed for some disappointment.
Investors face the “good news is bad news” paradox
Part of the paradox facing investors in the current environment is that solid economic data may cause equity markets to become more volatile, and potentially even challenged, at current lofty valuations. Our economic expansion is now in its record-breaking 11th year, and we are arguably late in the economic cycle. We don’t forecast a recession, but we expect economic growth to slow.
In December of last year, the Fed was still projecting plans of rate hikes in 2019. By March, expectations of rate cuts were becoming deeply embedded in the market psyche.
This creates a counter-intuitive environment where good economic news can become bad news for markets, as Fed rate cut expectations are reduced. Recently, U.S. data has looked solid, causing some to question the justification for Fed rate cuts. There does not seem to be a consensus within the Fed about the rationale for cutting rates. In fact, we may even see one or two FOMC members dissent on the rate cut decision on Wednesday.
Finally, some of the largest challenges facing the U.S. economy, like a growth slowdown in Europe and China and lingering trade tensions, are not directly addressed by lower U.S. policy rates. The Fed’s appetite to continue to ease policy may be more limited than markets expect.
Indeed, slower growth abroad is impacting our financial markets as well as threatening to weigh on U.S. economic prospects. In Germany, the yield on 10-year government bonds is negative 35 bps, hovering at the record low. Negative-yielding debt is spreading and is dragging down U.S. real interest rates. We see this as a long-run challenge for investors. One or several Fed rate cuts may prop up valuations for now but are not a silver bullet against the chronically low interest rates that erode income.
Investors may look to manage the volatility inherent in a late-cycle economy, particularly should the Fed pivot again to a more cautious stance after a likely rate cut on Wednesday.
1 Reflects Bloomberg futures pricing as of close of business on July 24, 2019.
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