Rates: The Dose Makes The Poison

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Rates: The Dose Makes The Poison

“An ounce of prevention is worth a pound of cure.” That’s about as close as Fed Chair Powell came in his comments at today’s Council of Foreign Relations discussion to addressing what has become the burning issue of the day: will the FOMC cut rates by 25 or 50 basis points at the July meeting?

St. Louis Fed President James Bullard had a more pointed take: “Just sitting here today, I think 50 basis points would be overdone”. Given that he voted for a 25 basis point cut just last week, this should hardly have been a surprise. But US equity markets dropped nonetheless.

Why the adverse reaction to his comment? Because Fed Funds Futures markets have been increasingly banking on a 50 basis point cut next month. The data here:

  • At yesterday’s close the odds of a 50 bp cut in July were up to 43%.
  • Just a week before, they were only 18%. A month ago, they were less than 1%.
  • By mid afternoon today, the odds of a 50 bp cut in July were down to 35%.

But here’s the funny thing about today’s Fed Funds Futures action: the odds that the FOMC will lower rates by 50 bp by the September meeting (the next one after July) actually increased from 54% to 58%. We listened to Powell’s comments at the CFR event and it’s easy enough to see why. The inability of the US economy to see measured goods and services inflation of 2% or more clearly worries the FOMC. Slower global growth and the uncertainties over global trade also play a role in their thinking.

On top of that, futures markets now have another cut by December as their most-likely case. The odds for rates 75 basis points lower than today are 40%. That is greater than the chance the Fed is done with 50 bps of rate reduction in 2019 (25%) or that only one cut will happen this year (5%).

All this raises 2 important questions:

#1: Have futures and bond markets overestimated the Fed’s likely trajectory of rate cuts in 2019? The easy answer would be “Yes”. Expecting 75 basis points of cuts before seeing any real softening in labor market conditions looks aggressive. Yes, inflation is running below expectations, but that’s hardly new.

Our view, however, is that markets have it more right than wrong.

  • The dollar remains strong, dampening exports.
  • Lower oil prices, even with geopolitical risk, are still almost 20% below last year’s levels. Measured inflation isn’t going anywhere.
  • And neither are US-China trade negotiations. Business uncertainty will only grow, and consensus estimates for Q2 and Q3 corporate earnings reflect zero growth. All that sets up for risk to the labor market as companies begin to adjust cost structures.

#2: How does the Fed think about the merits of a 50 bp cut versus 25 bp?This is a case where “the dose makes the poison”. A larger cut in the absence of a clear reason may actually create more problems than it fixes. Investors will rightly wonder what the Fed knows or fears may be coming down the road.

Our bottom line to all this: absent a shock, the Fed will move deliberately but slowly to lower interest rates rather than taking outsized measures and that is better for stocks over the next 6 months anyway. Our view that equities will see some churn in Q3 is largely predicated on a mismatch of Fed action versus market expectations, and we saw that start today. As for the bigger picture, however, the die is cast. Interest rates are heading lower and that should support US equity valuations.

Fed Funds Futures: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html