July 2019

Tug-of-War: Slowing Growth vs. Easing Monetary Policy

U.S. Fixed Income

The U.S. Fixed Income team cautions that the tug-of-war between slowing growth and accommodation will likely be accompanied by periods of heightened uncertainty.

Key Takeaways

  • The Fed’s ability to engineer a soft landing is a delicate task, and as the tug-of-war between slowing growth and easing monetary policy plays out, it is likely to be accompanied by periods of heightened uncertainty.
  • Futures markets are expecting as many as three U.S. interest rate cuts in the latter half of 2019, while in June, the Fed’s policy making body projected that rates will remain unchanged between now and year end.
  • With the U.S. economy in a relatively healthy state, it is the preexisting slowdown in global economic data coupled with the re-escalation of trade uncertainties that we believe present the biggest threat to the economic outlook and could be the impetus for a Fed cut in 2019.

From the Federal Reserve’s (Fed) January pause to its June pledge to “act as appropriate to sustain the expansion,” Fed policy shifts have helped support markets in 2019. While the U.S. Treasury market has rallied and interest rates have declined significantly on concern that the Fed’s more accommodative policy is driven by weakening economic conditions, risk markets, including equities and corporate credit, have honed in on the potential benefits of rate cuts. Interest rate cuts may ultimately be supportive for the U.S. economy, but investors should be careful what they wish for, given that what drives them typically is not. The Fed’s ability to engineer a soft landing is a delicate task, and as the tug-of-war between slowing growth and easing monetary policy plays out over the next few quarters, it is likely to be accompanied by periods of heightened uncertainty.

Futures Markets Dovish, but Fed Data Dependent

Markets are expecting the Fed to cut. In fact, futures markets are anticipating the fed funds rate will close 2019 at 1.625%, which suggests we could see as many as three interest rate cuts before year end. However, after the Fed’s June meeting, its economic forecast remained unchanged, and Chairman Jerome Powell stressed that any future action would be driven by a weakening of the central bank’s outlook. This distinction is critical, because while there has been a decline in certain measures of late, we would argue that the U.S. economy remains relatively healthy, perhaps too healthy for the Fed to reduce rates multiple times before year end.

U.S. GDP growth registered 3.1% in the first quarter of 2019, corporate earnings – while decelerating – are still growing, unemployment is at a multi-decade low, wage pressures are contained and consumer spending remains strong. The assumption that the Fed will implement an insurance cut to reverse the current mid-cycle slowdown amid a constructive economic landscape could ultimately lead to disappointment, particularly when projections of the Federal Open Market Committee (FOMC), the Fed’s policymaking body, are still skewed toward holding rates steady through year end, as shown in Exhibit 1.

Exhibit 1: FOMC Projections versus Fed Fund Futures

Futures markets are expecting multiple interest rate cuts before year end, while the Fed’s policymaking body projected rates would remain unchanged this year, with only one cut in 2020.

Source: Bloomberg, as of 6/21/19

Trade: The Biggest Threat

The Fed did not commit to action at its June meeting, but it is clear that the central bank stands ready to react, and quickly, if warranted. In our view, the preexisting slowdown in global economic data coupled with the re-escalation of trade uncertainties presents the biggest threat to the economic outlook and could be the impetus for a Fed cut in 2019.

Despite the Fed’s pivot and China’s recent stimulus, global manufacturing data has continued to decline this year, as highlighted in Exhibit 2. While the U.S. is hovering just above the critical level of 50, many regions have dipped into contraction territory. This picture is unlikely to improve if trade tensions further weigh on business confidence and preclude business investment.

The U.S. and China may have come close to an agreement in May, but negotiations remain challenged as these economic superpowers seek to alter policies that were decades in the making. And as the Trump administration sets its sights on other regions, and the rules of the game remain in flux, businesses are having a difficult time making investment decisions. If these headwinds generate concerns of a corporate earnings recession, confidence in the Fed’s ability to engineer a soft landing could wane, in which case we would expect risk assets to reverse course.

Exhibit 2: Global Purchasing Managers’ Indices

Global manufacturing data continues to soften, and when coupled with trade uncertainties, could be the impetus for a Fed cut in 2019.

Source: Bloomberg, data to 5/31/19

A Potential Change in Framework

Outside of a material decline in the economic outlook, a change in the Fed’s inflation targeting framework is the next likely reason for a rate cut. The Fed is evaluating its future target framework given that its preferred measure of inflation has undershot the central bank’s 2% target for 10 years now. Average inflation targeting – targeting 2% over a specified time period – is the solution that has accumulated the most support. This framework would result in the Fed maintaining easy monetary policy until inflation rises and, to offset sustained periods of below target inflation, allowing above-target inflation for a period of time without raising rates. We would expect a change in policy of this nature to be very well telegraphed, and implemented in a slow and methodical manner, making it an unlikely event for 2019.

When the Cuts Come, Will They Be Enough?

The prospect of cuts is driving risk asset valuations higher, but it may be time to start questioning the degree of easing necessary to sufficiently stimulate the economy and support risk assets going forward. Will a few rate cuts be enough to combat the global economic slowdown, declining global trade and waning U.S. fiscal stimulus? Likely not if trade tensions persist and business confidence continues to decline.

It also remains to be seen how the consumer will react to rate cuts given the differences that have emerged in consumer habits following the Global Financial Crisis. As rates have steadily declined, consumers have actually been borrowing less as shown in Exhibit 3, and consumer spending has been relatively constrained. During the impending rate-cut cycle, lower rates and consumer spending – the primary driver of the U.S. economy – may not provide the level of stimulus they have in cycles past.

Exhibit 3: U.S. Consumer Debt to GDP and Fed Funds Target Rate

Leading up to the crisis, falling rates spurred borrowing and increased consumer spending, but in the historically low rate environment since, consumer borrowing has actually declined.

Source: Bloomberg, data to 12/31/18

Planning for the Tug-of-War Between Slower Growth and Accommodation

The prospect of the Fed having investors’ backs is appealing to market participants and, reminiscent of 2012, when the European Central Bank (ECB) vowed to do whatever it takes to preserve the euro, we think both rates and spread product can continue to perform well in the near term. U.S. Treasury yields have trended significantly lower, and can go lower still on the back of the Fed pivot, expectations of a lower neutral rate¹ in the U.S. and the potential for renewed accommodation by the ECB. Nearly $13 trillion of negative-yielding debt around the globe (Exhibit 4) and an insatiable search for yield are also contributing to strong demand for U.S. government and corporate bonds. Supply/demand technicals also remain favorable for U.S. investment-grade corporate credit.

Exhibit 4: Negative-Yielding Debt

As countries around the world employ ultra-accommodative monetary policy to combat declining growth prospects, negative-yielding debt has ballooned to nearly $13 trillion.

Bloomberg, as of 6/21/19. Depicts the Bloomberg Barclays Global Aggregate Negative-Yielding Debt Market Value in USD. The Bloomberg Barclays Global Aggregate Bond Index is a broad-based measure of the global investment-grade fixed-rate debt markets.

After a wave of mergers and acquisitions, we are witnessing a heightened focus on debt paydown and less willingness by management teams to take debt and leverage higher as they have in recent years. Further, while the U.S. economy is slowing, employment and corporate fundamentals remain relatively robust. Given these conditions, it is difficult to envision a sustained sell-off in corporate credit without recession risks and default rates trending higher. However, there is no doubt that the landscape can change quickly.

As markets await a resolution on trade and the tug-of-war between slowing growth and accommodative monetary policy wages on, investors may benefit from seeking out active managers with the ability to distinguish between short-term volatility events and growing systemic issues. Managers with the ability to adjust portfolios accordingly may be better suited to take advantage of strong risk-adjusted opportunities while the threat of recession remains at bay and also to avoid the trouble spots that will get hit the hardest when things come unglued.

1The neutral rate is the interest rate that supports the economy at full employment/maximum output while keeping inflation constant.

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