Knowledge. Shared Blog

June 2019

Fed Serving Up What Market is Craving

Co-Head of Global Bonds Nick Maroutsos and Portfolio Manager Jason England explain why the Federal Reserve was correct in not cutting rates Wednesday and which factors may justify a move lower in July.

Key Takeaways

  • The Fed’s removal of its “patient” language gives the central bank room to lower interest rates at its July meeting should the domestic and global economy exhibit signs of softening.
  • Although the U.S. economy appears stable, the risks posed by rising trade barriers, the absence of inflation and evidence that the Fed is willing to step in at any hint of a wobbling equity market (recognizing this week’s record close) all increase the plausibility of a July rate cut.
  • Lower policy rates will likely steepen the yield curve on the front end, punishing investors who seek income while keeping duration low.
View Transcript

Nick Maroutsos: Jason and I are here to talk about the Fed meeting yesterday and why it’s important to investment implications going forward. So Jason, yesterday the Fed met. As expected, they left rates on hold, but they did not rule out the case for further cuts down the road. What was your interpretation?

Jason England: I think they did the right thing. I think it was a little premature to cut yesterday at the June meeting. I think they did change the language a little bit to more dovish, like you mentioned, so it is taking out the word “patient” and now they are going to closely monitor the implications of incoming data. And I think what they have done now is left open the optionality for the July meeting.

Maroutsos: Look, I think July is becoming a very pivotal meeting. The market is pricing in interest rate cuts, equities are at all-time highs, but you also have, like you said, some optionality where the Fed has time on their hands to sort of survey the data. There will be earnings, jobs data, GDP figures that come about, and we are also looking at doing this in a period of time where they are trying to manage through the rest of quantitative tightening, doing so when equities are at all-time highs. Look, it does actually throw easing policy, contrary to what probably should be happening, but, unfortunately, it looks like the Fed may be a bit painted into a corner and will be forced to cut interest rates at some point in time. The question is, do they cut 25 or do you think they can actually go 50 basis points like some of the market participants are expecting?

England: I think the difficult thing with them, if they were to go 25, it’s not as, you know, the market has that priced in, and I think it wouldn’t be as drastic to the market as a 50-basis point cut. Now a 50-basis point cut I think would be something to look at because if you look at past history, they have had abut 500 basis points of room to maneuver. They only have about half of that now. So, if you did 50 in one meeting, are they going to stop and pause there? Or are they going to continue to move down?

Maroutsos: Yeah, I think that’s a good point, because traditionally, this hiking cycle has been far shallower than previous hiking cycles. But to your point, there isn’t a lot of room for them to go if we do get into a crisis, so cutting now, when the economy is doing okay – data points are okay, equity markets are at an all-time high – could be construed as a little bit premature. But again, I think the market may force their hand. I think one of the big worries that I have is the lack of inflation and that’s really maybe one of the critical things that actually forces them to move.

England: I agree, I think that is the key point. I mean if you look at growth is at or near trend right now. You are at full employment with a low unemployment number. The jobs data, although it was weak at the last print, it’s still on average over the last three months, it is solid. So really the only thing that is holding them back is the inflation number, and the other big item on the table is the trade tensions. And that’s why I think the June meeting wasn’t the opportune time to cut is because you have the G20 later this month in June, so with that you might see some relaxing of the trade tariffs and tensions between China. So it was a good meeting for them to adjust their tone to more dovish, but now, what is their next step at the July meeting and on through the rest of the year?

Maroutsos: You know, one of the other things that I think we need to talk about is the global picture. Growth globally has slowed, other central banks are looking to ease policy or remain on hold. How much do you think that factors into the Fed’s decision for them moving policy?

England: I think that’s, it is a big part of what is factoring into their decision now is because, like I said before, the data in the U.S., is still solid and it’s still strong. And the U.S. is still growing, and I think if you take aside the trade tensions, we may not even be in this situation of looking at cuts, but when you look at the bigger global picture, that’s where they see other central banks now that didn’t really ever get off the ground, are now looking to ease and cut, as we have seen the RBA already do. So I think the concern with the Fed is if they don’t make a stance or a move, then they may fall behind the other global central banks and it could be detrimental to the curve in the U.S.

Maroutsos: Right, and I think one of the things we have always talked about is that it’s kind of the elephant in the room, whereas the Fed is mandated to look at inflation and unemployment, but they are also looking at the equity markets. And granted, equity markets are at near or at all-time highs, but you also throw in the fact that the Fed is there to backstop the markets, the Fed pivoted in earlier this year following the equities’ fall in Q4 of 2018. So if we do get a stumble in the equity markets, could we see the Fed looking to cut interest rates even more aggressively?

England: Yeah, and I think that’s where you might see your 50-basis point emergency cut that they might have to backstop the equity markets. And I think obviously the other thing we haven’t talked about yet is Trump, President Trump, and his constant beating on Powell and the Fed to cut rates, and, they don’t want to, they are independent and they don’t want to capitulate to him. But at some point, if they have to backstop equities or global growth or global data and inflation in the U.S. doesn’t come up, then I think they are going to have to look down that road of maybe doing an emergency cut, a little bit more than what they are accustomed to.

Maroutsos: Right, so it’s going to be a challenging environment. I think positioning on the front end makes sense, obviously, looking to take advantage of curve steepener because the likelihood of a Fed easing or easing policy will lead to further curve steepening, which is something that we have seen already. And ultimately, pricing that out through the front end of the curve makes an attractive investment, certainly relative to CDs, particularly with rates dropping now.

England: Yeah, I think that is a key point you just hit there, is obviously as you have seen the 10-year [Treasury yield] today drift below 2%, short-term rates are going lower and you are not going to be able to sit in a CD or money market and get enough yield. We are getting back to the levels where we are going to have low short-term rates, so you need to figure out what part of the curve are you going to be able to invest in.

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