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While many argue that an interest rate cut from the US Federal Reserve (the Fed) will not help blocked supply chains, we see other arguments in favour of additional accommodation. A shift is coming, and it’s coming soon. Here’s why.
Interest rate cuts are now priced in
The recent drawdown in global equity prices and the corresponding contraction in financial conditions have sparked a debate about whether the Fed should respond, especially in light of growing global concerns around coronavirus. Indeed, with many market participants now expecting a full 0.25% interest rate cut by June, and three rate cuts this year, the debate is only growing more intense.
Will they/won’t they?
We believe there is an important distinction that must be made in this debate. And that is between whether the Fed should respond, and if they will respond. While much of the discussion focuses on the former, it is the latter that matters most. We actually believe both that the Fed should respond, and indeed, may be close to doing so. As a result, we’re expecting to see US Treasury yields to continue to fall, potentially toward 1.00%.
We believe there is an important distinction that must be made in this debate. And that is between whether the Fed should respond, and if they will respond.
Why the Fed should cut rates: Growth, appearances and inflation
There are four primary reasons why we believe the Fed should and will respond:
- Business and consumer confidence
- If not now, they risk having to do more later
- Acting to stem a decline is more favourable than not acting at all
- Inflation
1. Rate cuts can stem the decline in business and consumer confidence
For a US manufacturer who cannot source parts from China due to their workers under quarantine, it’s likely that a 0.25% or even 0.50% rate cut doesn’t help you. We agree that today’s environment is a unique supply shock that is more properly dealt with from the fiscal side (i.e. government action). And indeed, governments from Hong Kong to South Korea have already acted on that front.
However, the counter argument still sees a role for the Fed and a motivation for them to act. While the Fed may not have the ability to restart factories in China, they can soften the blow to the markets and to the economy from the coronavirus, even if just through confidence channels. Or coming from the opposite angle - if market, consumer and business confidence is declining rapidly, and they do nothing, they could accelerate the downside of all of those with a Fed that is unresponsive and ‘out to lunch’.
2. If not now, then when? Saving stimulus ammunition for the future is a gamble
Admittedly, we have never been fans of the ‘save the ammo’ argument. The argument essentially hinges on a taking a major gamble with the US economy by staying on hold. If the outlook is deteriorating, but the Fed stays on hold, there are two main potential outcomes:
- The first outcome sees the clouds pass and the declines have only minor damage. A sharp rebound follows.
- The second situation sees a deteriorating outlook endure. And by lack of action from the Fed, it likely accelerates further. Because of this, the Fed is now further behind the curve with little room to maneuver given already low rates.
If the gamble pays off, great. But if the Fed made the wrong choice, they have potentially caused significant damage to the economy and open themselves up to significant criticism and likely a loss of independence.
3. Simply human incentive structures argue acting to stem a decline is more favourable than not acting at all
Like in point 2, the incentive structure surrounding the Fed argues for action. If the Fed doesn’t act and the markets and eventually the economy accelerate downward, they risk getting the blame for the worse economic outcomes. If they act to stem the decline, they can defend their actions – at least they attempted to assist in the public interest. If they do not, it will be hard to defend against the public, Congress, and an already vocal President.
4. The strongest argument, however, is the defend their inflation mandate
While most of the debate centers around growth, we believe the risks to inflation are also critical. Recent developments present an increased risk to the inflation outlook, in our view. Already the Fed has begun to shift the narrative around their potential future actions to defending inflation and inflation expectations to the downside, given the fact they have not consistently reached their inflation target for the last decade.
Now, US market inflation expectations are once again falling, and once again have shown an asymmetric tendency to fall quickly, and only rise slowly (and rarely return to previous levels). Market inflation expectations are important because falling inflation expectations are believed to eventually lead to lower actual inflation.
US Market inflation expectations are once again falling... inflation expectations are important because falling inflation expectations are believed to eventually lead to lower actual inflation
Why sooner rather than later?
The situation looks familiar…
The recent declines in financial conditions and inflation expectations are similar to changes seen the previous two times the Fed shifted tack: the December 2018-January 2019 period and the summer of 2019, the latter of which eventually led to three Fed rate cuts. In addition, the inversion of the US yield curve has also reached similar levels – an indicator that historically is a strong indicator of a future recession.
The Fed is against the clock
Additionally, the Fed has a limited amount of time to signal a reaction in the near term. Due to blackout rules, 7 March is the day blackout begins for the March Federal Open Market Committee meeting. So if the Fed is going to signal a shift, they need to do it before that, or else there is an 11-day period where markets will be left to their own devices.
Due to blackout rules, 7 March is the day blackout begins for the March Federal Open Market Committee meeting. So if the Fed is going to signal a shift, they need to do it before that, or else there is an 11-day period where markets will be left to their own devices.
When? Expect a shift in language and tone by the March meeting, latest
It’s important to be clear here that we do not think the Fed is likely to announce imminent rate cuts. But we do think there is a high probability their language becomes more supportive for markets. If this does not occur before the 7 March blackout, we certainly would expect a clear signal at the 18 March Federal Open Market Committee meeting.
What does all this mean for markets?
While we do not see a March rate cut from the Fed currently, the situation is evolving rapidly, so anything is possible. Without an actual rate cut, while we do see coming eventually, the Fed verbally shifting their approach may not push US Treasury yields lower just yet – instead it may serve to only justify the current low yields. In our view, it will limit the extent to which yields can rise in the medium term.
