Expectations are building in the bond markets that the US Federal Reserve is about to embark on an easing cycle starting in July, and market pricing suggests that rates will be 0.75% lower by year-end than at current levels.
To date, Chairman Powell has given little away, affirming at every opportunity a neutral stance with the promise of reacting in either direction if necessary. The FOMC meets next week and analysts will scrutinise the statements, the Summary of Economic Projections and the Press Conference for further clues. In our opinion, there is a good chance that the markets will be left speculating for a bit longer about FOMC thinking, and that the neutral stance will be retained.
We come to this conclusion based on the published economic data, which shows that the US economy is still solid and performing better than the US Federal Reserve had expected so far this year. The pace of expansion is admittedly slower in 2019 than was the case last year, but remains around potential and the Economic growth forecasts that will be published are likely to show an upgrade. Inflation on the other hand is likely to be revised down slightly. Both observations would represent an outcome that the FOMC should be delighted with, and would suggest that there is no need for rates to be either higher or lower at present.
The infamous “dot plot” – which shows how the committee members see interest rates evolving over the next few years – will in all likelihood continue to show an upward path in rates into 2020, completely at odds with market pricing. The validity of the dot plot has to be questioned in an easing cycle as the FOMC does not pre-plan rate cuts, and is instead usually reactive to events, crises or recession. The FOMC also forecasts a long run rate, which is currently at 2.75%, which again looks vastly different from bond market pricing. Using the forward curves, rates are expected to be around 2.15% in 10, 20 and 30 years’ time, illustrating how far the bond market has ‘front run’ Federal Reserve policy expectations.
So why would the FOMC start to lean towards easier monetary policy, and what would be implied by a move to an easing stance? Firstly and probably most importantly, by signalling an ease the implication is that we have seen the top of the interest rate cycle. That should surely mean the long term rate must be lowered substantially, closer perhaps to the average rate of the last 10 years which is a mere 0.5%. This would perhaps be a bit extreme (as it does include the immediate post-crisis period), but even over the last 5 years it is still less than 1%. This is more than 100 basis points lower than that implied in the market, and over a whopping 175 basis point difference from the FOMC’s current estimate.
Thus, reverting to an easing stance is hugely significant, and to my mind too big a statement to make at the current juncture when the US economy is performing well, employment is still rising and financial conditions are easing. Should they do so however, yields across the whole of the fixed income universe have a long way to fall. A change in stance like this may well also be positive for riskier assets, as the move is perceived as less of a response to concerns but more a “recalibration” of Fed thinking about what the “neutral” rate for the economy is. On an international comparison, US interest rates are far higher than in Europe and Japan, as President Trump is so fond of pointing out.
The FOMC have surprised us a couple of times this year. We should remain alert to more surprises as they could be even more meaningful than what we have seen already.