A string of weak economic data releases and the return of trade tensions with China and Mexico have further diminished the economic outlook lately, which is encouraging traders and investors to price in rate cuts by the Federal Reserve to support the economy. Market participants closely monitor the future direction of US monetary policy, as it is one of the main drivers of asset classes including equities, bonds and forex. Nevertheless, several traders and investors seem to be overestimating the likelihood of multiple rate cuts this year. It is crucial for market participants to tame their expectations towards a more realistic scenario, in order to make better trading/investment decisions, as disappointments from the Fed could halt the rally in asset classes like equities, short-term Treasuries and EUR/USD.
Probabilities of rate cuts are rising
Economic data releases have been reflecting a weakening economy lately, the latest of which being May’s non-farm payroll number, which came in at 75k vs. 185k expected. The slowdown in the US economy finally seems to have hit the labor market. Moreover, ISM Manufacturing PMI for May also came in weaker than anticipated; 52.1 versus 53 expected. This slowdown in the domestic economy has been accompanied by a flare-up in trade tensions once again, with China and Mexico. Furthermore, the trade concerns with Europe have not completely disappeared either. These global trade disputes and softer economic data are diminishing both the US and global economic outlook, and has encouraged the Fed to turn more dovish.
From James Bullard, to Lael Brainard to Jerome Powell himself, Fed members have expressed their willingness to adjust monetary policy going forward if needed. More specifically, in reaction to rising trade uncertainties, Powell stated that the central bank “will act as appropriate to sustain the expansion”. Dovish statements by the Fed have emboldened traders and investors to anticipate rate cuts going forward this year.
FedWatch, which is the prominent indicator for the chances of fed funds rate moves by the central bank based on futures contracts, is currently indicating high probabilities of rate cuts for upcoming meetings. The table below exhibits the probabilities of rate cuts for each of the 2019 FOMC meetings (at time of writing).
19th June 2019
31st July 2019
18th September 2019
30th October 2019
11th December 2019
Moreover, FedWatch is indicating that there is a 35.5% chance the fed funds rate target range will be 1.50%-1.75% by December 2019 (at time of writing), reflecting three rate cuts from the current target range (2.25%-2.50%). However, these expectations appear stretched from reality. While a softening economy and rising trade tensions do warrant a dovish approach to monetary policy, expecting three rate cuts while the US economy is still growing at around 3% is irrational.
Yes, the GDP growth rate will certainly fall from current levels as a result of these trade tensions going forward, and the Fed may want to stay ahead of the curve by providing accommodative support to the economy, which would most likely be in the form of a rate cut. However, take into consideration that Powell has also recently expressed concern over the fact that the Fed lacks ammunition in terms of loosening monetary policy conditions in the event that the economy faced another downturn/ crisis.
Jerome Powell recently claimed that:
In short, the proximity of interest rates to the ELB [Effective Lower Bound] has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.
This suggests that Powell is keen to save some loosening ammunition for a time when it is most needed, such as if we were clearly on the verge of a recession. With GDP growth still around 3%, the current trade/tariffs war does not incur the need for back-to-back three rate cuts. Instead, it would be more rational to expect the Fed to cut once, and then use the accompanied press conference to express Fed’s willingness to remain accommodative, while adopting a ‘wait and see’ approach to observe the effectiveness of the first rate cut and evaluate whether more are needed.
Therefore, while the probabilities for rate cuts are very high (near 100%) for three 2019 meetings, one should approach the chances of rate cuts as function of conditional probability. Whereby if the Fed cuts in September, then the probabilities for rate cuts in October and December will fall, whereas if they don’t cut then the probabilities for these meetings will rise, or at least remain elevated (if they reach full 100%). Accordingly, if the Fed were to cut rates in October, then the probability of a rate cut in December (and beginning 2020 meetings) would fall.
What does this mean for traders and investors?
Regarding equities, a rate cut would be cheered and would help support stock prices. However, a rate cut may have been well priced into the market by the time the Fed does so. Furthermore, the Fed’s reluctance to cut rates again after the initial cut could hurt investor sentiment. If economic conditions/ trade tensions continue to weaken while the Fed refuses to cut again (and prefers to ‘wait and see’), it could push stocks lower as market participants are forced to unwind their bets for even looser monetary policy conditions despite worsening economic conditions, which is a very undesirable scenario for market participants. Nevertheless, the Fed’s communication would play a big role in these circumstances; if the Fed finds the perfect balance between keeping rates on hold and conveying the willingness cut if needed going forward, then this could provide some support for equities. That being said, the current anticipation of three rate cuts is setting the equity market up for disappointment. If the Fed would need to cut that rapidly, it would mean the economy will be tanking in the second half of this year, which wouldn’t be supportive for stocks either (even despite a dovish Fed).
In terms of the Treasury market, a rate cut has already been priced in, with the 1yr yield currently at around 2% (at time of writing). If the Fed cuts rates, and probabilities for rate cuts in the remaining 2019 meetings drop (as the Fed turns to ‘wait and see’ mode), then this could inhibit short-term yields from falling much further, and consequently inhibit short-term Treasury prices from rising higher.
Moreover, if the Fed refuses to cut rates again while economic conditions/ trade tensions worsen, then this would further diminish the future economic outlook, which would push longer-term yields lower, and consequently trigger the 10yr Treasury price higher. Hence, the 10yr Treasury would be the place to put money to work if the undesirable scenario of ‘rates on hold/ economic conditions worsen’ turns into reality after a potential initial rate cut.
With regards to the US Dollar, the anticipation of rate cuts by the Fed would encourage market participants to bet on a weakening greenback. If the Fed does indeed cut rates, then this would certainly inhibit the Dollar from rising. However, it is important to take into consideration how other central banks are moving to fight-off economic weakness as well. If the Fed adopts a ‘wait and see’ approach after an initial rate cut, while other major central banks continue to cut rates and engage in monetary policy easing, then the Fed could end up unintentionally strengthening the USD, as other currencies weaken relative to the greenback. For example, the Dollar has recently been weakening against the Euro in anticipation of a dovish Fed, as the EUR/USD rate has recently climbed up from $1.11 to $1.13. Though market participants should beware of betting on further weakening in the USD in the event that the ECB were to decide to adopt ultra-loose monetary policies again to support its weakening economy. This risk remains subdued presently as Mario Draghi has recently failed to turn dovish enough to support Eurozone’s struggling economy. However, USD bears should beware of a potential scenario where the Fed turns to ‘on-hold’ mode, while the ECB members (and other central banks) are forced to turn increasingly dovish to accommodate their economies.
Traders and investors have gotten ahead of themselves by expecting three rate cuts this year, and are setting themselves up for disappointment. Recent dovish communication from Fed members, especially from Powell, does not seem to imply more than one rate cut this year. Interpreting rate cut probabilities as a function of conditional probability allows for a more realistic approach to trading/ investing in various asset classes. The initial rate cut is likely to be followed by a drop in the probabilities of rate cuts for future 2019 FOMC meetings, and potentially also for 2020 meetings. Hence, the disappointment of no further rate cuts (after the initial cut) could reverse the current directions of various asset classes, which includes the rallies in equities, Treasuries and EUR/USD.
The only scenario in which more rate cuts would be warranted would be if economic conditions/ trade tensions aggravate considerably, which would still not bode well for risk assets (equities) regardless of a dovish Fed. Nevertheless, if the Fed does indeed disappoint markets following one rate cut, the 10yr Treasuries appear to be attractive assets to hold as the economic outlook deteriorates.
The statements following the FOMC meeting on Jun. 19, 2019 should provide more clues regarding the outlook for monetary policy going forward, and allow market participants to be better informed when positioning themselves in various asset classes.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.