Coin flip for the Fed
Bottom Line The Federal Open Market Committee (FOMC) voted 7-3 Wednesday to cut interest rates by a quarter point for the second time in three months, lowering the federal funds target range to 1.75-2%. It marked the most contentious Federal Reserve policy-setting meeting in three years as there were three dissents: two bearish and one dovish. Regional presidents Ester George (Kansas City) and Eric Rosengren (Boston) voted to keep rates unchanged, while James Bulliard (St. Louis) voted for a half-point cut.
What message should investors glean for future monetary policy decisions? The dot plots show seven members believe the Fed will cut rates once more this year, five think rates are fine just where they are and five feel rates should be a quarter-point higher. Investors, for their part, are pricing in at least one more rate cut this year—the last FOMC meetings are on Oct. 30 and Dec. 11—with perhaps another rate cut or two over the course of 2020.
While Fed Chair Jerome Powell said that the U.S. economy and labor market remain strong, he alluded to a number of geopolitical risks, including the ongoing trade and tariff war with China, which necessitated the insurance cut. He did not commit to any future course of policy action, but indicated the Fed would remain vigilant and cut rates again if necessary.
Inverted yield curve flattening From an oversold 3.25% in November 2018, benchmark 10-year Treasury yields plunged in a massive flight-to-safety rally to an overbought 1.45% in early September 2019, as investors were pricing in the risk of recession. But over the past fortnight, yields spiked from 1.45% to 1.90%, as recession fears have faded.
The yield curve (as defined by the upper band of the fed funds rate of 2% and the 10-year Treasury) is still moderately inverted, but is much flatter today than when the fed funds rate was at 2.5% earlier this summer. If the Fed successfully orchestrates another insurance cut this year, the yield curve likely will have re-steepened, signaling diminished recession risk. We continue to believe that there is no imminent risk of recession before the first half of 2021 at the earliest. As we review Wednesday’s decision and look out over the rest of this year and into 2020, we believe that the Fed is attempting to balance three ideas.
Data dependence Except for manufacturing, the U.S. economy is in pretty good shape:
- The labor market hasn’t been this strong in half a century. Just yesterday, initial weekly claims for the September jobs report flashed at 208,000, just off a 50-year low
- The consumer is strong, with confidence just off an 18-year high, and retail sales solid for the past six months through August
- Inflation has firmed, with year-over-year increases in August for both core CPI (2.4%) and PPI (1.9%), while the core PCE has stabilized at 1.6% in both June and July, with an increase of 1.8% expected for August
- Manufacturing is weak, likely due to overseas concerns, with the ISM manufacturing index in August hitting a contractionary 3-year low at 49.1. But manufacturing accounts for only 11% of the economy, and factory and nominal durable goods orders both turned positive in June and July, while industrial production and capacity utilization were surprisingly robust in August
Geopolitical risks The Fed took several overseas concerns into account with its two insurance cuts this year:
- The trade war with China seems to be thawing, with both Presidents Trump and Xi offering concessions ahead of high-level meetings in October and the Asia-Pacific Economic Cooperation (APEC) Summit in Santiago, Chile, on Nov. 16-17
- Brexit deadline on Oct. 31
- Japan’s VAT tax increase on Oct. 31
- Transition from Mario Draghi to Christine Lagarde as head of the European Central Bank on Oct. 31
- Ongoing Iranian nuclear and energy issues
- German recession risk
Independence Trump has been inappropriately pressuring the “boneheads” at the Fed to cut interest rates to help boost the economy and the financial markets, and his tweets on Wednesday were no exception. “Jay Powell and the Federal Reserve Fail Again. No 'guts,' no sense, no vision! A terrible communicator!” The Fed needs to demonstrate independence from the administration’s taunts, so Trump’s name-calling likely will prove counter-productive.
Conclusion While we continue to expect pockets of equity-market volatility, in part due to investor uncertainty surrounding Fed policy, we believe that we will gain greater clarity on many of these geopolitical risk issues in coming months, which will help to drive stocks up to our year-end target of 3,100 for the S&P 500.