On the Minds of Investors
06/06/2019
Q: Is a Fed rate cut on the line?
Market expectations for the U.S. Federal Reserve (Fed) to cut rates continue to build. The Fed Fund futures has moved to price a 50% probability of a 25bps rate cut for the June 18/19 meeting, and over 90% chance by September. This view is reinforced by St. Louis Fed President James Bullard, who said on Monday “A downward policy rate adjustment may be warranted soon to help re-center inflation and inflation expectations at target and also to provide some insurance in case of a sharper-than-expected slowdown.” This call for flexibility to deal with weaker growth momentum is also reinforced by Fed Chairman Jerome Powell on June 4.
It is important to emphasize that the current level of economic activity in the U.S. is still decent. The jobless rate, below 4%, is at its lowest in decades and general consumption indicators are still in good shape.
The doves would argue, however, that economic clouds are gathering on the horizon. The Fed will need to start acting soon to stay ahead of the curve. The recent developments in U.S. trade tariff policies, notably against China and Mexico, could dampen corporate sentiment. The Institute of Supply Management manufacturing index came in at 52.1 in May. This is still above 50, indicating manufacturing expansion, but it is the lowest reading since October 2016. Meanwhile, inflation continues to track below the Fed’s target. Core personal consumption expenditure (PCE) deflator, the Fed’s preferred inflation measure, stood at 1.6% in April, versus the its target of 2%. In fact, the core PCE deflator has been below target 95% of the time since 2010. This gives the Fed more ammunition to cut rates without breaching its price stability mandate.
Since late 2018, the bond market has been slowly pricing in rate cuts. The inversion of the 3-month and 10-year U.S. Treasury curve, to some extent, also reflects investors’ concerns over U.S. growth outlook. We have long argued that years of quantitative easing by global central banks cast doubts on the reliability of such signal. That said, the latest trade policy backdrop, and subsequent impact on business investment, adds more credibility to this narrative of a rising threat of a recession. While the Fed should not be cutting rates simply because the market is expecting one, the central bank will need to weigh up the potential market disruption if it fails to manage investor expectation in an orderly fashion.
EXHIBIT 1: United States: Monetary policy
FOMC and market expectations for the fed funds rate
Source: Bloomberg Finance L.P., FactSet, Federal Reserve, J.P. Morgan Asset Management.
Market expectations are the federal funds rates priced into the Fed Fund futures market as of 31/05/19. Federal Reserve projections shown are median estimates of FOMC participants. Guide to the Markets – Asia. Data reflect most recently available as of 31/05/19.
Investment implications
For the Fed to start cutting rates in or before September, U.S. economic data in weeks ahead would need to deteriorate significantly. 2Q GDP (advanced numbers to be released on July 26), non-farm payrolls and durable goods order are key data to watch out for. A rapid escalation in trade tension between the U.S. and China, or the U.S. starting another front of trade conflict, would also push the Fed to take prompt action to protect growth. The updated Summary of Economic Projections by the Fed at the June 18/19 Federal Open Market Committee (FOMC) meeting will be closely scrutinized for FOMC members’ latest view on economic and policy outlook.
A rate cut environment should see investors to take a more defensive position. Income generation would be the priority as cash return across Asia would decline further. High dividend equities, especially in more defensive sectors, could benefit in a falling yield environment. In fixed income, long duration U.S. government bonds have already performed well with higher bond prices in recent months, the 10-year U.S. Treasury yield has fallen from 2.7% since the start of the year to below 2.1%. This winning streak could continue. In the short term, investors may choose to seek safety with high-grade corporate debt, instead of high-yield debt, in fear of credit spread widening. However, the low yield environment should eventually persuade global investors to return to the high-yield space in search for income.
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