The Fed is on hold for now, but it might not take much to change that

Interest rates are on hold for now — Federal Reserve officials have indicated as much and the market believes it — but the state of affairs could be fleeting amid an ever-changing set of economic conditions.

Pretty much everyone is convinced the Fed is finished for 2019, a year in which it cut its benchmark rate three times to a range targeted at 1.5%-1.75%. What happens in 2020, though, is open to wide interpretation.

In congressional testimony last week, Fed Chairman Jerome Powell said current policy is “likely to remain appropriate” as long as growth continues and inflation trends to 2%.

But several Wall Street experts think the central bank will have to cut at least once more in 2020, with some expecting as many as three quarter-point reductions.

“We believe that ½% growth in the first half of the year will compel the FOMC to cut,” UBS economist Seth Carpenter said in a recent note to clients. “Indeed, with our Q4 forecast for GDP growth at 1.2%, we think some apprehension will start to rise even this year, but we expect them to hold off cutting until early next year.”

From a market perspective, traders in fed funds futures are implying a rate of 1.27% by the end of 2020. That in turn would indicate something like a 56% probability of two cuts.

All of that, of course, is a long way off.

The ‘recession meme’

In between, the Fed will have plenty to navigate, from slowing growth to the evolving state of U.S.-China trade negotiations and, not least, the complicated dynamics of the 2020 election. President Donald Trump has been a fierce Fed critic and has demanded lower rates and more easing. He and Powell met Monday to discuss multiple issues.

Economic expectations have changed at least somewhat for the better, making Fed policy perhaps a bit less predictable.

Whereas historically reliable recessions signals, like an inverted bond yield curve, flashed red earlier this year, they’ve since reversed and most economists expect at least sluggish growth. That may still not be enough to keep the Fed on the sidelines.

“This recession meme still has quite a bit of life to live because it will eventually hit the consumer,” said Sebastien Galy, senior macro strategist at Nordea Asset Management. “I think the Fed eventually will through a process of easing.”

Galy sees the likelihood of two or three more cuts as well, which might not be enough to satisfy Trump, who has said he’d like to see the U.S. adopt the zero- and negative-rate regimes in Europe and Japan.

“The White House started the fight, but the Fed might actually decide to finish it. If they do ease, they won’t ease as aggressively,” he said. “It’s a mistake to fight a central bank that’s independent, because it eventually can fight back.”

Investors will get a little more insight into the thinking of policymakers when the Federal Open Market Committee, which sets monetary policy, releases the minutes from its Oct. 29-30 meeting Wednesday. The committee approved a quarter-point cut at that meeting but gave the first indications that a pause was now ahead.

The contrarian view: A possible rate hike

Fed officials have expressed concern that global slowness could infect the U.S., and that inflation remains below the Fed’s 2% target.

Another impetus to cut rates would be that while the yield curve has inverted, the difference between the 10-year Treasury and the fed funds rate is too still too narrow.

“Unless the yield curve steepens further, monetary policymakers will need to lower interest rates again sometime early next year,” Joe LaVorgna, chief Americas economist at Natixis, said in a note.

While the primary thinking is that any move would be lower in rates, Jim Paulsen, the chief investment strategist at the Leuthold Group, holds a contrarian position, namely that better than expected growth could force the Fed into raising rates.

“That’s how everyone’s interpreting it,” Paulsen said of the inclination toward lower rates, “but you just get the sense that it wouldn’t take much more here and all of a sudden the bond market’s going to be telling the Fed they’ve got to raise rates.”

He sees inflation continuing to ride higher and growth improving in a way that could send the Fed back to tightening.

“In some sense it does get a little more dicey for the Fed when they could get between two very different views from the bond market and Trump,” Paulsen said. “I think it would be OK if it wasn’t election year to boot.”

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