Fed rate cut — what to expect when expecting

Late last year, I read an article containing predictions on US Federal Reserve (Fed) policy and the level of the 10-year US treasury rate for 2019. It was a couple months before the Fed raised rates for the fourth time in December and hinted that at least two more rate increases could take place in 2019.

The US 10-year treasury yield was also north of 3% and was heading higher. Strangely enough though, when most people were forecasting one or two more hikes for 2019, there was one analyst suggesting that the Fed would cut rather than raise rates in 2019. He also expected the 10-year rate to fall below 2%.

I remember saying to a colleague at the time that this guy must either be “crazy” or he has a crystal ball that is working brilliantly. Little did I know how right he was! For after stating earlier this year that there would be no rate hikes in 2019, the Fed is now set to cut its policy rate at its upcoming meeting at the end of July and the question is by how much. Some market participants, however, still question the wisdom of cutting rates at a time when it is not needed.

Arguments for a cut include: the need to address a slowing US economy, which is likely to get worse from slowing global growth being affected by, inter alia, ongoing tariff wars and Brexit. Additionally, there’s the suggestion that if the Fed doesn’t cut now in the presence of still muted inflationary pressures it risks deflation which it has little experience with; and a rate cut is

also believed to be necessary to end the run of an inverted US yield curve — a recession indicator.

Those against a cut say the US economy is not actually weak as evident in recent data such as the strong jobs report for June, and retail sales data for June, which showed continued strength of the US consumer and still low levels for jobless claims.

Another argument put forward is that the recent slowdown in trade and capital spending can be traced directly to the fickleness of trade negotiations, which can be reconciled at a moment’s notice, and would quickly restore confidence in the business community, helping to restimulate growth. There’s also the view that cutting might be seen as bowing to political pressure, especially given the strong jobs report for June.

In sum, the growing consensus is that the Fed will most likely cut rates, starting with 25 bps. This will be seen as an “insurance cut”, to sustain the current US economic expansion, which is one of the longest, if not the longest, on record. However, it has also been suggested that a 25bps cut will be inadequate to boost inflation or even steepen the yield curve and so a 50bps cut would be more appropriate. I expect the Fed, though, to proceed with the 25bps “insurance cut” and then wait for future data to determine whether any additional rate action is required.

Bonds, like equities, have been benefiting from a sharp reversal in Fed policy since the start of the year and bonds, in particular, are expected to continue to perform well as the Fed become even more accommodative causing rates to fall even lower. Earlier this week, an analyst from JP Morgan even suggested that the US 10-year rate could fall to 0%!

Such an outcome would definitely redound to the benefit of high quality long-dated bonds but not necessarily so for riskier investments (including equities) as a 0% yield would suggest that the US economy is experiencing a sharp slowdown or is in a recession. In any event, I do not expect to see the US 10-year at 0%, but then again, I do not have a “brilliant” crystal ball.