Fed pivots on rates – What’s the market impact?
The Fed just lowered interest rates for the first time in a decade. The rate cut itself is small – only 25 basis points or 0.25% – and unlikely to make a big economic difference on its own. But if history is any guide, this move means the Fed is unlikely to raise rates again for quite some time. That is a big deal, and an important input to our asset allocation decisions.
Why is the Fed cutting rates?
The Fed’s move is a contentious one. Analysts and investors are rigorously debating whether the Fed is making the right move:
- In favor of holding interest rates steady: Economic data has not deteriorated meaningfully in recent months. Inflation is lower than the Fed would like, but relatively stable. GDP growth, if slower than before, is still tracking above the U.S. long-term average. Job creation has been strong. So, why give the economy more support now, leaving the Fed less ammunition in the event of a real downturn? Why risk inflating asset prices beyond what is healthy for investors?
- In favor of cutting interest rates: While headline economic data has been mixed, the sequencing of that data provides strong evidence that the U.S. economy is slowing. Leading indicators such as business investment and confidence have been weakening 12-18 months. The Fed cares most about inflation (elusive) and full employment (poor wage growth). Economic health is a more urgent concern than financial stability. Cutting rates now will improve confidence and sustain the business cycle.
Investment contracted in the second quarter, raising concerns about future growth
Contribution to percent change in real GDP, seasonally adjusted annual rates
Sources: New York Life Investments Multi-Asset Solutions, U.S. Bureau for Economic Analysis, 7/31/19.
We see strong merits to both arguments, but ultimately side with cutting rates. Since January, the Fed has signaled it would slow its pace of monetary policy normalization. In that same time, markets began to price between 50 and 100 basis points of interest rate cuts over the next year. It’s unlikely that the Fed relies heavily on market cues when making its decision. However, that information does demonstrate to the Fed that a supportive interest rate environment is likely lower than current levels. If the Fed wants to sustain the economic expansion, it should cut rates.
What does the Fed need to do moving forward?
The Fed will face two key challenges over the next several months. First, it will need to move slowly and deliberately, gauging its policy moves against changes in economic data amidst a market that would like it to move more quickly. This is particularly difficult since monetary policy takes several months to filter its way through to the real economy. The data is always mixed, making this balance less straightforward.
Second, the Fed needs to be very careful with its communication. An impatient market increases the risks that even supportive moves will be viewed negatively if considered “one and done”. Not all Fed governors see the economy and its risks in the same way, but they should work to reassure markets that they are watching economic data and related risks carefully.
What does it mean for markets?
The market expects 100 basis points of interest rate cuts, four times what the Fed did today. But it is unlikely that we see the Fed move that quickly, leaving room for disappointment in the short term. Markets priced a 20% probability of a 50 basis point interest rate cut today; we expect some volatility as that hope is not met.
Taking a longer-term perspective, a slowing economy and rich valuations have encouraged us to move more defensively in our portfolios. We are staying invested and would consider market consolidation and opportunity to add more active risk. If more supportive interest rates give this economic cycle another chance at life, we stand ready to capture that upside. In the meantime, we are focusing on securities that provide quality and income and thus relying less on price appreciation to add value.
For further analysis, see Lauren Goodwin on Bloomberg Daybreak, July 31 2019 (video, beginning 12:30).
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