The Fed is poised to cut rates in July so get ready. That’s our takeaway from all that we saw and learned from the FOMC’s statement, fed funds dot plots, forecasts, and press conference. While there were some analysts proclaiming the Fed didn’t really shift its rate and economic forecasts all that much so why the big Treasury rally, we think the dovish/easing shift was more decisive and that’s what surprised us. We came into the meeting believing that while the Fed had provided a dovish surprise at the prior three meetings, the only way to accomplish that on Wednesday would have been to cut rates. Well, we were wrong. As everyone now knows they didn’t cut rates Wednesday but they still managed to provide a dovish surprise that had both equities and bonds rallying. We think they cut in July (regardless of a China trade deal), and that cut will be followed by more before year-end. Read on below for more detail on why we have that outlook.
As we mentioned above, we came into the FOMC meeting thinking the Fed would not cut rates and thus the market was poised for some disappointment on the short-end as the rally there had seemed to be forcing the Fed’s hand. And while odds of a rate cut at the June meeting were only around 20%, whispers nonetheless abounded that a cut would be forthcoming given the drop in inflation expectations and the aforementioned short-end rally that had the 2-year note nearly 50bps below the effective fed funds rate of 2.37%. So when the statement was issued and the no-change rate decision was announced the short-term and long-term Treasuries both rallied in unison and equities joined in the rally as well, but with a little less vigor. So why that reaction?
First, the dot plots reflected a considerable degree of dovishness despite the median not changing for 2019. The counter to that is that in March no FOMC participant forecast a rate cut in 2019. The June forecast had eight of seventeen participants penciling in rate cuts in 2019 with seven of those expecting 50bps in rate cuts by year-end. That shift from no 2019 rate-cuts in the March forecast to eight participants expecting cuts in the June forecast indicated a material shift in outlook over the past three months. In the press conference, Powell pointed out that even those participants forecasting no rate hike were mostly predisposed to an easing lean. In essence, it wouldn’t take much to get them on board with a cut. That’s probably something we’ll see more clearly when the minutes are released. That, as much as anything, contributed to the robust Treasury rally.
Second, changes in the statement also indicated a much more dovish tenor. First the “will be patient” phrase as it relates to rate changes shifted to “act as appropriate” indicating a new willingness to move and move quickly. The other big language shift was the addition of “increasing uncertainties” as it relates to the economic outlook. That arises from the ongoing trade-related headwinds and the somewhat newer geo-political developments (i.e., Iran). They also removed the “transitory” descriptor as it relates to lower-trending inflation. Recognizing that PCE trends and “market-based expectations” (i.e., TIPs breakeven inflation rates) were both trending lower and away from the 2% target indicated a new level of concern and removed any inflation-related constraint to cutting rates.
A couple more points need to be made that lead us to believe the Fed cuts in July (even with a China trade deal). While the 2019 GDP forecast didn’t change from March at 2.1%, it nonetheless represents an expectation of a material second-half slowdown. Recall that the March forecast came before first quarter GDP was known. With first quarter subsequently printing a surprise 3.1% and second quarter expected around 2% that implies a first half GDP around 2.5%. Knowing that and forecasting a full-year 2.1% implies a slowing in the second half to around 1.6%. Thus, the reported no change in GDP is actually an expectation of slowing second-half GDP.
Also, and this comes from the press conference, Chair Powell didn’t push back at all with the market expectations of 75bps in rate cuts and didn’t push back on a question regarding single cuts being 50bps. Another point from the press conference, Powell made reference to the “Chicago conference” which was part of the “Fed Listens” tour that traveled to various Fed districts to gather local “on the ground” input on economic issues. He made the point that what came through loud and clear from those events was that people who haven’t fully experienced the economic expansion would rather the Fed focus on engendering conditions that lead to better job opportunities rather than focus on inflation fighting. In essence, the message for the Fed was do what you can first and foremost to further the economic expansion. Chair Powell seemed to take that as a key insight as it’s in the statement (“act as appropriate to sustain the expansion”).
Thus, with inflation pressures moribund, the Fed is essentially freed to adjust policy that first and foremost helps to extend and deepen the economic expansion. That means to us that a rate cut is coming in July, almost regardless of the data. The market is ready for a cut, and the Fed seems ready to cut as well. The only other question is will it be the first of many and we think it will be. The market’s 75bps in expected rate cuts this year seems very doable to us.
Dot Plots Reflect a Sudden Urge to Cut Rates
The Fed’s dot plots of expected fed fund rates from the Wednesday meeting were a treasure trove of information. First, it reflected for the first time a group of eight that foresee cuts coming this year with seven expecting 50bps in cuts. No member expected cuts in the March dot plot, so that is a decided shift in sentiment in a brief time. Further, the longer-term rate was cut from 2.75% to 2.50% continuing a decline in this rate which further cements the lower-for–longer rate outlook. That rate is likely to become a magnet for the 30-year bond and if it resides around 2.5% that can only mean decreasing yield expectations for 10-year notes as well.
|Treasury Curve||Today||Chg Last Wk.||LIBOR Rates||Today||Chg Last Wk.||FF/Prime||Rate||Swap Rates||Rate|
|3 Month||2.12%||-0.06%||1 Mo LIBOR||2.38%||-0.02%||FF Target Rate||2.25%-2.50%||3 Year||1.665%|
|6 Month||2.02%||-0.16%||3 Mo LIBOR||2.39%||-0.04%||Prime Rate||5.50%||5 Year||1.688%|
|2 Year||1.71%||-0.15%||6 Mo LIBOR||2.30%||-0.04%||IOER||2.35%||10 Year||1.907%|
|10 Year||1.99%||-0.11%||12 MO LIBOR||2.26%||-0.07%||SOFR||2.36%|