The Funds Rate is Heading Lower

The most recent communication from the Federal Reserve has been clear. The mid-cycle adjustment is complete and the economy and Fed policy is in a good place. The decision for the Fed to pause was a prudent one. And as we head into 2020, the Fed will be easing again.

Larry Kudlow indicates a Phase 1 deal is down to “short strokes”.

Let’s take a look

MARKETS

The week ends with the hope of a Phase 1 deal. 2019 has been all about global trade. And it continues to be about global trade into 2020.

We are very happy the Fed paused. Negative rates, inverted yield curves, recession: there’s nothing constructive with any. But we do think the Fed will need to bring the Funds rate a touch lower in 2020 ahead of the next leg of our fiscal outcome.

We have spoken at length during the course of this year about the normalization process of the Federal Reserve. And most of this coming from 2016-2018. In reality, the normalization of rates occurred too late. But when it did occur, it was because of relief on the fiscal side. It didn’t last long.

The Fed has had it. This has been one of the biggest whipsaw years with Fed policy perhaps in the history of the Fed. Forget about the dissenters, in listening to Powell this week there is little doubt the Fed is pushing back.

The global central banks need help. Low rates will not solve it. Central banks simply can’t sit back and do nothing and this is where we’ve been and are at again. It feels, though, like this time will matter more than last.

This Week

Powell spoke about deficits and the unsustainable nature of how our politics has evolved. It’s worth noting he’s not the first Fed Chairman to do so, although now the evidence is present.

The recent hiccup in the Repo market is not of coincidence. We are issuing too much debt and the Fed needed to buy it. Interest rates are low, negative and available across the globe.

This week the Fed spent a considerable amount of time talking about the concept of lower rates as the new norm globally: lower rates, inflation and growth.

Is it the truth or a hedge on the most recent decision for the Fed to once again move lower in rate:

The notion that, if we’re wrong, here’s the reason why. More below.

FROM THIS WEEK THE MESSAGE IS CLEAR AND CONSISTENT

Powell

https://www.federalreserve.gov/newsevents/testimony/powell20191113a.htm

Clarida

https://www.federalreserve.gov/newsevents/speech/clarida20191114a.htm

Williams

https://www.newyorkfed.org/newsevents/speeches/2019/wil191114

Rates Price Action

This week has been about the bond market pricing out some optimism around trade, geopolitical and economic risk in Hong Kong and the Fed embracing the new norm of “low” across the board (rates, inflation and growth).

Should a deal get done, the details and outcome will matter. Specifically, with regards to economic impact and potential upside surprises. The market is aware now of the dynamics around the tariffs and economic impact and will digest the deal fairly succinctly. 

From a market risk/reward perspective, 10-year yields would likely retest the recent highs in yield (1.95%) should a deal get signed. Through 1.95, we target a break of 2% and a move toward the June/July highs coming in around 2.15.

Conversely, a failure to ink a deal should begin to push 10-years back toward the lower end of the recent range toward 1.50% heading toward the end of 2019. 

The economy has slowed. And GDP will continue to come in lower than expected. This period in time in many ways similar to 2015-2016. GDP in the latter stages was sub 1%.

There continues to be a battle with rates. Yet in the end, clarity is what is necessary to drive a broader move in both outright level and yield curve. The economic outlook is still unclear with rate markets trading within their ranges, albeit slightly broadened.

THE FED

Powell

Chairman Powell completed his two-day testimony this week. And the story and new narrative is now complete: 

“the economy and policy are in a good placeThe theme of the new norm: low rates, inflation and growth”

In many ways, it’s a sad narrative. On the flip side, the Fed is sending a clear message to the fiscal side of our equation: get your act together. Deficits are unsustainable and central bank policy alone will not solve our problems. It’s not the first time we’ve heard this from central bank heads. 

So many criticize the Fed. And we have certainly found room this year. Their narrative has changed to fit the desired outcome (higher AND lower Funds rate) and the outcomes have been consistently wrong.

In fairness, central banks will not just sit back and do nothing when they sense trouble. And there’s been a sense of trouble out there. Negative rate policies a different story. The Fed is right to pause here and reevaluate over the next few months. 

Powell delivered as expected for us. His main theme was consistent with the Fed speak of late: The Fed is on hold. But..

Full text of Powell’s testimony below: 

https://www.federalreserve.gov/newsevents/testimony/powell20191113a.htm

Some excerpts

“We see the current stance of monetary policy as likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook of moderate economic growth, a strong labor market, and inflation near our symmetric 2 percent objective”

“This favorable baseline partly reflects the policy adjustments that we have made to provide support for the economy. However, noteworthy risks to this outlook remain. In particular, sluggish growth abroad and trade developments have weighed on the economy and pose ongoing risks” Indeed!

 “Moreover, inflation pressures remain muted, and indicators of longer-term inflation expectations are at the lower end of their historical ranges. Persistent below-target inflation could lead to an unwelcome downward slide in longer-term inflation expectations. We will continue to monitor these developments and assess their implications for U.S. economic activity and inflation”

The Fed continues to have a problem on their hands. China has weakened, the President is fighting a trade war and the United States Dollar is the king despite the Fed cutting rates.

It’s a challenge. And in the end, should the current dynamics continue, the Fed will be lowering rates more next year. 

The debate continues about the efficacy of lower rates. And we completely agree. 

But monetary policy does not operate in isolation, just like the global economy. And the real justification for the Fed to hold tight will be driven by how the global economy evolves.

In the end, 2020 will be no different than this year if the global economy does not recover.

It should be no surprise that US inflation expectations have not recovered. We are importing global disinflation at the moment. And unlike other periods in recent time, the trade war presents a more formidable and structural challenge. The Fed’s aware, they simply haven’t seen it before and have been slow to react. 

Below a speech by NY Fed President Williams this week:

Williams: “No Man is an Island”

https://www.newyorkfed.org/newsevents/speeches/2019/wil191114

Excerpts from Williams

Lower growth, inflation and neutral 

“These structural shifts are having fundamental effects on real interest rates, growth, and inflation. A number of advanced economies have inflation below desired levels and longer-term interest rates that are well below where they were a decade ago.

There are, of course, a few outliers, but the commonalities between the world’s developed economies are becoming more and more apparent.

There’s no doubt that the U.S. is experiencing first-hand the effects of the structural shifts in demographics and productivity growth. But the fact that these changes are a common experience for so many developed economies creates challenges to our economic prospects at home”

Beyond sluggish inflation, we’re starting to see signs of slower global growth playing out in the U.S. data. While consumer spending is holding up, other parts of the economy—including manufacturing, exports, and business investment—have seen growth stall or experienced outright declines.

Data dependent, not data point dependent

If the Fed had a motto, it would probably be “data dependent.” When asked about this, it’s important to clarify that while I’m data dependent, I’m not data-point dependent.

The Fed is on hold. And the risks to inflation still to the downside: it’s in the charts and Powell said it explicitly.Furthermore, the outcome of the Phase 1 deal will matter. It’s unlikely the Fed moves rates again this year. Yet, heading into next year should growth and inflation expectations not pick up, the Fed will likely revisit whether the current level of the Funds rate is stimulative. 

Where are we at?

This year is far from over. Last year it was the Fed, this year trade. The rate market continues to take back the optimism around a Phase 1 deal.

It’s all about risk-reward heading into the latter stages of 2019. 

And with the US rate market trading near the upper end of the range, the onus shifted to the stakeholders on trade to justify the levels this week.

Outcomes. The markets needs legitimate outcomes at this point. And when listening to Powell speak this week, no doubt the Fed is on hold.

Yet, equally no doubt the Fed is nervous about the outlook heading into 2020. 

The US rate market will lead from here. And with the Fed on hold right now, the yield curve will be largely directional: flattening with lower rates and vice versa.

With the current posture from the Fed (which could change but not right now), a continued move lower in rates from here will likely bring a flatter curve. 

“Short-term, although on hold the Fed is still very much in play”

In his Q/A, Powell did push back on the fiscal side. And rightly so. He made it clear that our budget deficits are an issue and that fiscal help would be needed in the next downturn. And clearly the concern is, if we don’t address the deficit issues, our opportunity to lend support on the fiscal side will be limited. 

On inflation the Chairman was consistent: the risk is “lower not higher”. The forward break-even inflation curve agrees. In a nutshell, the inflation outlook as it stands, skews the Fed toward more cuts at the moment. The bar for hikes even higher. 

Powell was clear this week on the outlook globally: the new norm is lower rates, lower growth and inflation. And to a large extent, there was resignation toward the thought of fiscal help in the near future. And although we think the Fed will ease more in 2020, it will be done kicking and screaming should it occur. 

On Repo, the Fed is still trial and error. We’ve been discussing the challenges in changing the liquidity/capital ratios. It simply doesn’t fly in this environment. Small tweaks perhaps, but this is largely a game of increasing reserve buffers within the Fed’s ample reserve framework. Like it or not, they are committed to their current framework. 

We didn’t get a strong sense from Powell this week on Repo. 

Verbatim: We need to continue to learn and adjust and the Repo situation has no implication for the economy or consumer. 

Although we disagree with the Chairman, we still expect the Fed to continue to use short term tools to keep the market liquid and stable through the remainder of 2019.

SUMMARY

This Fed’s mindset is slow. Literally. And we’ve studied it across the board.

But to be clear, the risks are skewed toward more not less heading into 2020. We are in full respect of the pause. It lends itself to prudence and reflection after a long year. But let’s not misconstrue the pause. The Fed is still in easing mode, and the likelihood of the Fed having it all in a good place at the moment is low.