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The Fed Ain't Making The Cut

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by: Michael A. Gayed, CFA
Summary

Jay Powell probably knew that after cutting rates by one-quarter point to a 1.75–2.0% range, and sending mixed signals, he would be taken to the cleaners. He wasn’t wrong.

A politically nudged Powell had good reason to be hesitant. The Fed typically cuts rates to stimulate a contracting economy.

It’s a thin line the Fed is treading on – there are indicators that made the Fed cut rates, and then, there are indicators that made it send hawkish signals.

We know what happens to people who stay in the middle of the road. They get run down. - Aneurin Bevan

Jay Powell probably knew that after cutting rates by one-quarter point to a 1.75-2.0% range and sending mixed signals, he would be taken to the cleaners. He wasn't wrong. President Trump unloaded instantly, calling him a failure and a terrible communicator without sense or vision. The savers were angry, business folks unhappy, and equity investors unenthused.

A politically nudged Powell had good reason to be hesitant. The Fed typically cuts rates to stimulate a contracting economy, maximize employment, and stabilize prices. The current indicators are contrarian. The American economy has been expanding for a decade, unemployment is at a 3.7% historical low, inflation is stunted at 1.7%, existing home sales rose 1.3%, and jobless claims rose lower than expected (208,000 vs 215,000 expected).

Despite robust indicators, the Fed went ahead with the cut. Perhaps, it was influenced by political arm-twisting; perhaps, it was because Powell saw a recession coming. Whatever the reasons may have been, this cut was unprecedented, though expected.

Powell's statement that the rate was cut to "provide insurance against risks" suggests that there is so much uncertainty around the corner that even the Fed can only guesstimate it. So, what is it that is bothering the Fed, and what are the chances of these risks materializing?

The PMI (Purchasing Managers Index) has been declining steadily (49.1 in August vs 52.8 in April), and per the Institute of Supply Management, there is a decrease in business confidence, with PMI softening after 35 months of growth. The drop is attributed to the Mexico-U.S. border-crossing delays and the U.S.-China trade impasse.

On the U.S.-China trade war, both countries are in blow-hot, blow-cold mode every alternate day. Businesses are hit, and voters are angry, and Republicans cannot afford to take any chance, with elections around the corner. The issue may be resolved prior to the elections. Also looking bad because of the trade war is China's falling GDP, which translates to lower demand for American products.

Then, there's the Saudi-Iran advanced stand-off that may snowball and suck in the U.S. into a full-fledged conflict. Troops intended for defense have already been moved to the region. Any war will add fat to the U.S. debt and cause an economic contraction.

Finally, the yield curve flattening too would have influenced the Fed's decision. As on 20-9-19, the 10-year treasury rate was 1.721% and the 2-year rate 1.687% - the difference being very meagre at 0.034%. The Fed cut the rates with the intention to steepen the curve, so that the banks can earn a sufficient margin to become enthused to lend to long-term projects. Because if banks don't, then recessionary signs may start knocking on the doors sooner than expected. Plus, an inverted yield curve and a flat yield curve are both signs of benign inflation in the medium term. With this cut, the Fed estimates the inflation rate to move up from 1.4% in 2019 to 1.9% in 2020.

Immediately before and after the cut, $20.7 billion poured into US risk assets for the week ended September 18, because investors needed to ensure a higher rate of return than that earned in bonds.

ETFs with perceived superior returns spiked hard. For example, YieldShares High Income ETF (YYY), which promises results that correspond to the ISE High

IncomeTM Index, and Invesco Dynamic Building & Construction ETF (PKB), which invests in securities that make up the Dynamic Building & Construction Intellidex Index, broke out of their ranges and spiked hard.

Summing up

It's a thin line the Fed is treading on - there are indicators that made the Fed cut rates, and then, there are indicators that made it send hawkish signals. Meanwhile, money is pouring into U.S. risk assets because the perception is that recession is imminent, and political push and shove will result in more rate cuts and a higher demand for U.S. risk assets.

The Fed weighed strong domestic data with a perception of weakness before making the cut. The inverted yield curve still has to play out, it's already days yet, and the endgame is unknown, but the opinion is that this rate cut, in the words of Jay Powell, "is no big deal," and it may not make the cut.

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.

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