Fed at the Mercy of the Markets (and a Trade War)

Martin Landry, CFA, CFP®, CAIA, CIMA®, CIPM, CTFA, AIF®, Manager of IMRG and Senior Portfolio Manager
August 2, 2019

In a dramatic shift in monetary policy, the U.S. Federal Reserve (Fed) cut short-term interest rates by a 0.25% at the conclusion of the July 31 Federal Open Market Committee (FOMC) meeting.

The reduction in interest rates by the U.S. central bank is the first since December 2008, a time when the world’s economies were reeling in a freeze up of liquidity during what is now known as “The Great Recession.” The move to cut rates on Wednesday by the Fed lowered the Fed Funds from a target of 2.25-2.5% to a range of 2-2.25%. Previously, the Fed had raised rates nine times (each in quarter point fashion) since December 2015.

In remarks delivered after the interest rate announcement, Federal Reserve Chairman Jerome Powell characterized the decision to lower rates as “insurance” against downside risks. While the rate cut has been widely-telegraphed over the last several months amidst ongoing tensions from U.S.–China trade talks and signs of a slowdown in global growth, the rate cut has not been without controversy and debate. In fact, in the vote of the FOMC members to lower rates, there were two dissenting votes.

The U.S. economy continues to grow at a healthy pace, consumer spending has been robust and consumer confidence is high during a time of continued low unemployment and modest inflationary pressures. However, some areas of the economy such as manufacturing have slowed this year. Even Chairman Powell admitted that the global slowdown in manufacturing is a bigger factor than they had expected last year.

Powell remarked that “it’s not the beginning of a long series of rate cuts” but later added that “I didn’t say it’s just one”, signaling a willingness to continue to lower the target rate underpinning everything from bank loans to home equity lines of credit to consumer revolving credit rates. Under political pressure from President Trump, Powell has a delicate balancing act in attempting to extend one of the longest economic expansions in American history. Trump, who is up for re-election next year, was calling for a 50 basis point cut. In a knee-jerk reaction, domestic stocks sold off about one percent and longer-dated Treasuries rallied. Financial markets dislike uncertainty as participants are trying to digest the future paths of interest rates. Negative stock market action after the announcement reflects two concerns for investors: 1) Is this the start of an easing cycle or just a “one and done” rate cut?; and 2) What risks to the economy does the Fed really see?

Critics such as Scott Minerd, Guggenheim Global’s chief investment officer, describe the Fed as “being in with both feet” and that they are now locked into a multi-cut cycle to sustain the economy. This is in conflict with the Fed’s primary mandates of controlling inflation and encouraging employment.

“They are convinced that they have to keep the economy expanding because they are afraid of the Japan disease spreading to the United States”, says Minerd. The reference to Japan relates to a term used to describe the decades-long degeneration of the Japanese economy from an industrial super-growth powerhouse to a low-growth, low-interest rate, deflationary and debtladen “zombie” economy.

Minerd said that “the Fed has no basis to really cut rates based on the economic data today. If you just looked at the face of the data, you would say that the Fed should be raising rates at this point, but obviously there is a backdrop of uncertainty around trade which would justify the Fed pausing and waiting a little bit longer.”

Our Economic Outlook:

  • Goldman Sachs economists are calling for slightly above-trend growth in the second half of this year, with the drag of financial conditions continuing to fade. They see U.S.–China trade tensions escalations as the biggest threat to growth. With one rate cut in the bag, Goldman sees the Fed delivering one additional 25 basis point cut this year and then remaining quiet next year leading into the 2020 presidential election.
  • Vanguard’s Investment Strategy Research Group believes that, owing to “intractable structural issues,” the U.S. and China have “likely reached an impasse” on resolving trade difficulties. In addition, Vanguard sees the recent imposition of a 3% tax on large global tech companies by France as a precursor to U.S. retaliation ahead of U.S.–European Union trade negotiations. Vanguard’s view on U.S. growth is more bearish. — They see a 40% chance of a U.S. recession in the next 12-to-18 months and a slowdown of the number of monthly job creations in the U.S. to below 150,000 by the end of 2019.

What the Fed rate cut means for borrowers:

  • In anticipation of the Fed cuts, the yield on the 10-year U.S. Treasury has fallen meaningfully in the last six months. Traditionally, mortgage rates are tied to the 10-year Treasury and thus over the last few months, rates for 30-year conventional mortgages have dropped to under 4%.
  • A rate cut means a corresponding rate cut for “the Prime Rate.” Set at 3% above the Fed Funds rate, the Prime Rate is the base rate for the most creditworthy clients and hundreds of billions of dollars in debt are tied to the Prime rate plus a spread. For most people, a reduction in the Prime Rate might show up in a lower rate for their home equity line of credit, an adjustable-rate mortgage or an adjustable-rate credit card.

What the Fed rate cut means for savers and lenders:

  • Falling rates mean that banks will offer lower interest rates on their savings and money market accounts. Certificates of Deposits (CDs) should also see a decline in rates.
  • Sadly, for savers, just the anticipation of a Fed rate cuts will cause banks to lower savings rates well ahead of the actual cut. This has happened this year.
  • People who need more income from their investments will continue to have to go down in credit quality to capture a higher coupon. This adds risk if and when during a future economic slowdown those lower-quality companies or entities struggle to pay their interest and have trouble refinancing their debt.

What the Fed rate cut means for stock market investors:

  • Lower interest rates are generally a positive for the stock market as the hurdle for being compensated for investing in the stock of a company is lower. Even if corporate earnings become stagnant, a price multiple paid for a stock might still rise. Given the capital structure, equity investors should be compensated for ownership of a company’s cash flows and thus, during times of cheap funding, the earnings of a company hold more value.
  • Coming off the severe market correction in the fourth quarter of 2018, the rally in domestic stocks during 2019 has been impressive. The markets have been expecting a rate cut for months and now, having gotten that cut, reactions will likely be polarizing. Divergence in opinion generally means increased volatility as market participants search to find the correct level to price stocks and determine the path of monetary policy and economic activity.

Sources:

  • Powell Says Fed Cut Not Start of Long Series, Drawing Trump’s Ire by Christopher Condon and Craig Torres, Bloomberg.com, July 31, 2019
  • Market and economic perspectives: July/August 2019, Vanguard Investment Strategy Group, https://advisors.vaguard.com/
  • Macro at a Glance: Latest views and forecasts by Allison Nathan and David Groman, Goldman Sachs Economic Research, July 31, 2019
  • Here’s what that Fed rate cut means for you, by Jessica Dickler. CNBC.com, July 31, 2019
  • Interview with Scott Minerd, Bloomberg TV, July 31, 2019
  • Winners and losers from the Fed’s rate cut, by James Royal, Bankrate.com. July 31, 2019.

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