Fed stays put for now—rate cut in July?

A perspective from E*TRADE Capital Management, LLC 06/19/19

In a nod to the resilient US economy and historically low unemployment, the Federal Reserve on Wednesday left short-term interest rates unchanged, which will keep the target Federal funds rate in a range of 2.25–2.50% for at least the next month.

The decision by the Fed’s policy-making arm—the Federal Open Markets Committee (FOMC)—was widely anticipated by market participants, although many believe the FOMC will pull the trigger on a rate cut at one of its upcoming meetings in July or September. That’s a significant change in sentiment from just six months ago, when market prognosticators expected the Fed to continue hiking interest rates in 2019.

FactSet Research Systems, June 19, 2019


The US economy has impressed...

If the Fed moves forward with a rate cut in the third quarter, it would mark the first time in more than a decade that the central bank has put the brakes on monetary policy, which could signal a key inflection point for the US economy.

The Fed has been on the sidelines since last December, when it hiked the Fed funds rate by 0.25% to its current range of 2.25–2.50%. Since then, unemployment has fallen to a 50-year low, GDP growth has consistently topped expectations, and the Fed’s preferred gauge of inflation has remained in check at under 2%.

…but job growth has sputtered…

Recently, however, the economy has sent mixed signals. In May, US employers added just 75,000 jobs—a sharp decline from the 224,000 jobs added in April, and the second time in four months that non-farm payrolls increased by less than 100,000.1 The economy is still growing, but job growth has been decelerating.

…and inflation is off target

The Fed has set its long-term inflation target at 2%, but its preferred gauge of inflation has only reached that number once in 2019. Higher inflation may seem like a counterintuitive goal, but for the Fed it’s a key indicator that the US economy continues to chug along. When inflation tails off, as it has of late, the Fed takes notice.

Trade tensions are also a concern

Meantime, trade-related issues continue to spook the markets. The White House has ratcheted up a long-simmering trade war with China while threatening Mexico with stiff tariffs if the country doesn’t do more to stem the flow of undocumented migrants to the US border. Although tariffs are off the table for now, they could be reintroduced if President Trump’s demands are not met.

Investors reacted to the volley of trade threats by sending stocks into a nosedive in May—the first down month for equities since last December. Notably, Federal Reserve Chairman Jerome Powell referenced increased trade tensions, saying in early June that the Fed is “closely monitoring the implications of these developments,” and “will act as appropriate to sustain the expansion.”2                                            

Of added concern is the Treasury yield curve, which has recently seen a partial inversion. As of June 18, 2019, the three-month Treasury bill was yielding 2.21%—15 basis points higher than the 10-year Treasury bond further out on the yield curve. Historically, an inverted yield curve has been a reliable predictor of recessions.

In isolation, none of these issues would likely force the Fed’s hand, and recently market sentiment has improved considerably. But taken in aggregate, the economy could be signaling that its long-running expansion is due for a breather.

Rate-cut probabilities for upcoming FOMC meetings

Source: CME Group, June 19, 2019. Data based on CME Group Fed fund futures contracts.


Investor takeaways

For now, economic fundamentals are sound and the Fed remains in a holding pattern—but the prospect of interest rate cuts in July or September could be consequential.

•  Keep an eye on inflation: Recently, the Fed’s preferred price index has fallen below 2%, which should remove a key obstacle to monetary easing. If inflation remains short of the Fed’s 2% target, the odds of a significant rate cut in the third quarter could increase measurably.

•  Lower rates could provide an economic and market boost: Both the US economy and the financial markets could benefit from lower interest rates, which can stimulate capital spending and spur consumer lending activity. In recent weeks, the mere hint of interest rate cuts has rallied the equity markets, despite the notion that monetary easing could point to a decelerating economy.

•  Don’t rule out defensive holdings: Although the Fed kept monetary policy unchanged this time around, potential rate cuts in July or September would signal that the FOMC sees potential threats to continued economic growth. That, in turn, could prove beneficial for high-quality bonds and defensive stocks—both of which can provide ballast in a decelerating economy.

The FOMC’s next policy-making meeting is scheduled for July 30–31. As of June 19, Fed funds futures put the likelihood of a 0.25% rate cut in July at greater than 70%, with a more than 60% chance of an additional rate cut in September.3 Any number of variables could affect the Fed’s decision, of course, but one thing is certain: Fed watching is officially back in vogue.

 

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1. Bureau of Labor Statistics, “Employment Situation Summary,” June 7, 2019. https://www.bls.gov/news.release/empsit.nr0.htm

2. Board of Governors of the Federal Reserve System, “Opening remarks, Conference on Monetary Policy Strategy, Tools, and Communications Practices,” June 4, 2019.  https://www.federalreserve.gov/newsevents/speech/powell20190604a.htm

3. CME FedWatch Tool, June 18, 2019. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

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