Markets ‘bullying’ Federal Reserve on interest rate cuts
Jan Hatzius, Goldman Sachs chief economist who long defied consensus by predicting the Fed would keep rates on hold, has now pencilled in two cuts for 2019 on the basis of hints from chairman Jay Powell and his fellow rate-setters.
Meanwhile, the Fed Funds futures market, which allows traders to bet on the direction of US interest rates, is pricing in three quarter-point cuts by the end of the year, beginning in July. Positioning in eurodollar futures, another popular contract for US rate wagers, is now at its highest levels since the peak of the European crisis, implying a strong conviction that easier monetary policy is just around the corner.
“I just don’t see the case for rate cuts, but [the June Fed meeting] was the most dovish outcome we could have had [without] an actual rate cut,” said Gregory Peters, a senior portfolio manager at PGIM Fixed Income. “Markets are bullying the Fed, and the Fed is responding.”
This raises a series of thorny questions. What would happen if policymakers refrain from cutting interest rates? If the Fed does cut, will it do so by the customary quarter point, or a more decisive half a percentage point?
And assuming the central bank does trim rates, will this be a precautionary move to bolster growth at a time of passing weakness, or will it solidify concerns over the slowing economy, leading markets into browbeating the Fed into a full rate-cutting cycle?
Not everyone is convinced lower rates are a done deal. Sceptics note that while economic data have softened over the past year and that resurgent trade tensions have cast a pall over the global economy, there is little to truly alarm officials at the Fed. Unemployment is at a half-century low, and interest rates — in a target range of 2.25 per cent to 2.5 per cent — are only barely higher than the main US rate of inflation.
Assuming that these figures do not deteriorate markedly, it is plausible that the Fed decides against trimming rates next month. More than half of Fed policymakers still forecast no cuts in 2019, and most of the doves are non-voters this year. Richard Clarida, Fed vice-chairman, has previously stressed that the central bank “can’t be handcuffed” by markets.
However, the Fed does appear to have painted itself into a corner. Given the rock-solid confidence that looser policy is now coming, markets could suffer a severe shock — similar to the turmoil witnessed last December — if the central bank does hold fire.
“There would be a lot of volatility,” warned Nancy Davis, chief investment officer at Connecticut-based firm Quadratic Capital Management. “The market has gone over its skis in pricing in rate cuts.”
The central bank itself appears to have been building a case for what economists have termed “insurance” rate cuts, to tide over a period of uncertainty. Back in April, Mr Clarida pointed out that the central bank lowered rates in 1995 and 1998, even though there was no recession on the horizon.
This was the rationale of James Bullard, president of the St Louis Fed, for voting for a rate cut in June to “provide insurance against further declines in expected inflation and a slowing economy subject to elevated downside risks”.
Mr Powell may have voted to keep rates steady, but he also seems receptive to the argument. “An ounce of prevention is worth more than a pound of cure,” he said at a press conference.
The question then becomes whether the Fed opts for a forceful half-point rate cut, as a number of investors and economists now expect. Financial markets indicate that would be only the start, with at least a full percentage point of rate cuts priced in over the next year or so.
Encouragingly for the Fed, interest rate futures indicate that traders think this will be enough to buttress the economy, leading to renewed rate increases from 2021, according to Morgan Stanley. The blitheness of the US stock market, which hit a record intraday high on Friday, indicates that equity investors also think the Fed will manage to forestall a recession.
However, it will be a fine line to tread, between giving the markets the rate cuts they crave and spooking them, through sending out too-gloomy signals on the global economy.
The margin for error is thin, warned Mark Haefele, chief investment officer of UBS Wealth Management. “Since 2009, the Fed has proven generally successful at pivoting the right way, but we are wary of positioning for perfection,” he said.