Why the markets liked the Fed's inaction
In the aftermath of the Federal Reserve’s decision Wednesday to keep interest rates unchanged, the S&P 500 surged to a record high of 2,958 on Thursday, while benchmark 10-year Treasuries also rallied, with yields falling to a new 3-year low of 1.97%.
We—and the markets—were expecting no change in rates but some nuanced messaging, and received much of what we wanted. Policymakers removed the word “patient” from their statement, took their prospective 2020 quarter-point rate hike off the dot board and set the table for at least one rate cut later this year, perhaps as early as the next policy-setting meeting on July 30-31. But the Fed did not address potentially truncating its balance sheet runoff, which is scheduled to end after September at about $3.6 trillion. Investors now believe with 100% probability that the Fed will cut rates in the second half of 2019, with the first of perhaps two or three rate cuts this year coming at the July meeting.
Why did the Fed choose not to act? There were two key reasons no rate cut was the right decision. First, the Fed needed to wait for the G-20 meeting in Osaka, Japan, on June 28-29, and a possible sidebar meeting between Presidents Trump and Xi, which we expect will go well and potentially get the critically important Chinese trade talks back on track. Not cutting rates keeps the diplomatic pressure on these two world leaders to consummate a much-needed deal. Second, the May nonfarm payroll report was aberrantly weak, and the Fed should wait for what we expect will be a better June report (with a possible upside revision to May) on Friday, July 5. To that point, this week’s initial weekly jobless claims data for the June survey week that ended on June 15 was solid at 216,000, suggesting that the June payroll report will be stronger than May’s.
Deflation concerns? In our view, inflation is relatively benign and stable, not decelerating into deflation or disinflation. To be sure, the Fed took its headline PCE forecast down to 1.5% for 2019 and also dropped the core rate as well, to 1.8%. But that’s in line with our own estimate here at Federated from the end of last year, when the core PCE was at 2%. We expected that core PCE would bottom at 1.5% mid-year, which it hit in March, and eventually grind back up to 1.8% to 2% over the next 18 months or so.
Dichotomy between strong consumer and weak manufacturing data The consumer is healthy, with a strong labor market and solid “Mapril” retail sales over Easter, which were revised up to a respectable 3.7% year-over-year gain. True, manufacturing remains weak, in part on uncertainty surrounding the China trade-tariff skirmish. But May's industrial production and capacity utilization rates were much stronger than expected. So perhaps manufacturing is bottoming here, with a possible bounce coming on the heels of better China trade news.
Leave the Fed alone President Trump has been inappropriately pressuring the Fed to cut interest rates to help boost the economy and the financial markets, and has been threatening to fire or demote Chair Powell for noncompliance. Trump does not have the legal ability to do any of that, of course, so the Fed needed to demonstrate some independence this week to help settle the markets.
‘Dry powder’ argument Federated’s out-of-consensus view is that there is no recession on the immediate horizon; we see the risk of one no earlier than in the first half of 2021. So the Fed, in our view, needs to husband as much dry powder as possible with its limited monetary-policy tools for when it legitimately does need to begin to combat the next recession, perhaps preemptively.
Looking across the valley Waiting now gives the Fed the opportunity to see how several key issues unfold over the next six weeks:
- G-20 meeting in Japan on June 28-29
- Core PCE for May on June 28 (1.6% estimate)
- June nonfarm payrolls on July 5
- June core CPI and PPI on July 11-12
- Start of the second-quarter 2019 earnings season on July 16
- Second-quarter 2019 GDP flash and annual benchmark revisions on July 26
Market risk later this summer? If some or all of these aforementioned developments and data points over the next six weeks are good, might the Fed choose again not to cut rates on July 31? With the equity market pricing in a near-certain chance of a rate cut, such an outcome could cause stocks to sell off over the typically choppy August and September period. For that reason, prudence may prove to be the best course of action for investors this summer.
Watch for my election special this coming Tuesday on the Democratic presidential candidates who will be debating next Wednesday and Thursday.