US in good shape despite rate cut

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The US Federal Reserve (Fed) has decided to cut short term interest rates by 25 basis points (bps) for the first time in over a decade in what analysts are calling an 'insurance’ move to maintain US economic growth.

The Fed lowered the target range for the federal funds rate to between 2.00% and 2.25%, with its committee highlighting risks surrounding trade issues with China and slowing global economic growth as the main catalysts.

‘This action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective are the most likely outcomes, but uncertainties about this outlook remain,’ the committee said in a statement.

It did not signal whether or not there would be more rate cuts to come.

In response to the move, which had largely been priced in by markets, BNY Mellon Investment Management experts do not predict the start of a major easing cycle.

Chief economist at BNY Mellon Investment Management, Shamik Dhar, says:

“In our view the Fed didn’t cut rates because its central forecast for the economy had deteriorated significantly, but rather because downside risks are rising and inflation remains low. In that sense it is being termed as ‘taking out insurance’. For that reason, we believe it is unlikely to signal the start of a major easing cycle - unless one of those downside risks materializes over the coming months.”

In the weeks leading up to the decision, the market priced in two cuts for 2019 and two for 2020. Some also thought the July cut would be by 50bps, although the majority of market participants were expecting 25bps.

Vincent Reinhart, chief economist and macro strategist at Mellon, a BNY Mellon company, says:

“The incoming data was mostly in favor of the modest course, as the Fed might find it hard to justify more than a 25bps ease in light of strong job gains and higher-than-expected consumer prices in recent months. But, some of the Federal Open Market Committee (FOMC) were leaning towards a 50bps cut. This raises the question, if not now, when?”

The rate cut in context

This is the first time the committee has lowered rates in over a decade. It last lowered rates in December 2008, after a series of cuts during the Global Financial Crisis, which took rates down to 0.25%. Finally, in December 2015 – following seven years on hold – the Fed switched gears and hiked 25bps. From then until December 2018, it had maintained a steady hiking cycle. Since then it has held still at 2.25% to 2.50%, a decision that has been commonly termed the ‘Powell pause’ in honor of FOMC chairman, Jerome Powell.

The 2010s still look set to be unique in terms of US monetary policy, as in every other decade since the 1960s the Fed has cut rates between 19 and 38 times.1

Is it truly an ‘insurance’ cut?

The market has labeled this an ‘insurance cut’ designed to curtail the impact that a global growth slowdown could have on the US economy. In contrast the rate cuts in the 2000s were deemed to be more reactionary rather than preventative. In this sense, expectations are that this most recent cut has more in common with the Fed’s 1998 moves, when it lowered rates by 75bps over the period of three months to lessen the risks associated with global factors at the time.2

BNY Mellon Investment Management experts do not think the Fed’s most recent move is indicative of a major easing cycle resulting in a zero rate or very low interest rate environment.

Gautam Khanna, senior leader of fixed income at Insight Investment, a BNY Mellon company, says:

“In the US I don’t see the same degree of demographic issues that are prevalent in Japan and Western Europe. If you look at other parts of the world, whether it’s Germany with a negative yielding Bund or Japan with more than 20 years of record-low rates, the biggest driver has been demographics—and the US doesn’t have that problem to the same extent.”

He cautions that one factor presenting further downward pressure could be the continued differential between US 10-year Treasury yields, most recently hovering above 2.0%, and the equivalent sovereign bonds in other developed countries, such as German 10-year Bund yields, which have mainly been between -0.20% and -0.40% since early June.

Yet he is doubtful we will see another two cuts before the end of 2019.

“I think three rate cuts in 2019 is a little bit aggressive, given the strength of the consumer and where unemployment rates are currently,” he concludes.

1 Fortune: A short history of fed rate cuts, 16 July 2019

2 Action Forex: 1990’s reloaded? Clues on the Fed’s path to “insurance cuts” 29 May 2019

 

Views expressed are those of the advisor stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Mellon, Insight Investment and BNY Mellon Investment Management are subsidiaries of BNY Mellon. ©2019 BNY Mellon Investment Management, distributor, 240 Greenwich St., New York, NY 10286.

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