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Federal Reserve Preview (31 July 2019)

Fed Chair Powell has strongly indicated intentions to cut the Fed funds rate, most likely a 25 bp cut with the potential to cut another 25 bps at the September meeting. As of writing, market pricing is suggesting an 80% chance of a 25 bp cut and a 20% chance of a 50 bp cut at the July 31st meeting.

In addition to an announcement on a rate cut, the market will be focused on language changes in the statement and in particular guidance on potential further rate cuts to come. Also, there may be an announcement on the Fed’s quantitative tightening program—which is currently set to expire in September. Any changes or announcements regarding the Fed’s balance sheet may impact the markets. Separately, at the last meeting James Bullard issued a dovish dissent, with a Fed rate cut Esther George may issue a hawkish dissent.

Fed communications preparing the market for a rate cut have focused on weak inflation, softening economic data, heightened global uncertainty (increased downside risks), and concerns over an inverted yield curve. With regards to the yield curve, a 25 basis point cut would likely not be enough to immediately uninvert the curve (10yr - Fed funds rate) given that the 10yr yield is currently around 2.05% and a 25bp cut would bring the effective Fed funds rate to around 2.13%.

While the last Fed hiking cycle (from 2004 to 2006) was a constant move higher in rates, historically it is not uncommon for hiking cycles to have periodic phases of rate cuts. A rate cut from the Fed does not necessarily signal the beginning of a prolonged easing cycle. For example the Fed cut rates in 1998, and then resumed hikes to the rate cycle peak in 2000. In fact, Greenspan reversed course many times, cutting rates only to hike them again later in the cycle in 1987, 1995, and 1998.Full Report Attached: https://www.merkinvestments.com/downloads/2019-07-31-merk-research-fed-chart-book.pdf

Nick Reece, CFA

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