Implications of rate cuts amid trade wars

September 20, 2019 09:10
US Fed Chair Jerome Powell and team are worried about global growth and uncertainty around trade. Photo: Reuters

As expected, the FOMC on Wednesday cut the Fed Funds rate by 25 basis points, taking it to a range of 1.75 percent to 2.00 percent, in its second such easing move this year. In addition to the reduction, the Fed cut the interest it pays on excess reserves by 30 basis points, greater than the funds rate cut, amid a breakdown this week in the overnight repurchase lending market.

We believe Fed Chair Jerome Powell’s key three messages remain intact:

1. The Fed will act as needed to maintain and expand the economic expansion in the US: Notably, Powell said that the US economy remains on solid footing, with solid job gains, low unemployment, and inflation remaining at 1.8 percent this year. While manufacturing has weakened, the US consumer, which comprises nearly 70 percent of the US economy, remains strong. Powell does not see a recession in the US on the horizon, and indeed noted that the inverted or flat yield curve could be due to a number of factors, including low and negative rates globally, which anchors US 10-year yields down as well.

2. Powell and team are worried about global growth and uncertainty around trade: The Fed chief noted that trade tensions escalated since the last meeting, and while they have since decreased, there is a chance for elevated volatility around trade. Beyond trade, we are seeing a notable slowdown in Europe and China, which could ultimately impact the US as well. Powell noted that some of the softness in US manufacturing could indeed be driven by these trade and global growth issues.

3. The mid-cycle adjustment, or “insurance cuts” remains the base case for now: While Powell was certainly open to “acting aggressively” if needed, the data and global picture currently point the FOMC to just a mid-cycle adjustment. Historical mid-cycle adjustments have been 3 rate cuts, or 75bps in total. This would imply perhaps one more rate cut this year. However, Powell will be highly data dependent now, and if there is a further deterioration in trade, US data, or global growth, we may see more than one more cut warranted.

The Fed’s “dot plot”, or median expected rate path going forward, calls for no more rate cuts in 2019 or 2020, and indeed a rate hike in 2021. However, there is dissent among the 17 FOMC members who contribute to the dot plot; 7 of these members believe one more rate cut this year is appropriate.

We continue to believe that the Fed will uphold its mid-cycle adjustment, and, barring any significant progress on trade or reversal in global economic fundamentals, we see at least one more rate cut likely, most probably in December. Bear in mind, in the interim we will also have Brexit on October 31, as well as further rounds of tariff increases in October and December. The next two Fed meetings are scheduled for 29-30 October, and 10-11 December.

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U.S. Investment Strategist, Allianz Global Investors