July rate cut: “Insurance” policy or recession guard?

Onsel Emre, PhD, CFA, Analyst, 08/07/19

July rate cut: “Insurance” policy or recession guard?

  • The Fed lowers interest rates to protect economic growth from downside risks.
  • We believe the central bank will cut rates by another 25 basis points this year.
  • Global economic growth is likely to stabilize at relatively low levels, limiting rate cuts.
The Federal Reserve delivered on its widely expected quarter-percentage-point interest-rate cut at the July meeting. It was the first reduction since 2008 and came in response to slowing global economic growth and muted inflation. The central bank also ended its balance sheet reduction two months ahead of schedule. Fed Chairman Jerome Powell left the door open to future cuts and indicated the path of the policy rate will depend on incoming economic data.

Making the case for more cuts

Eight of 10 Federal Open Market Committee (FOMC) officials voted to lower rates. Two FOMC members dissented in favor of holding rates steady. Powell did not provide any guidance on the extent and timing of future rate cuts. This probably reflected the lack of consensus within the FOMC. The Fed signaled a few months ago that it may lower rates because of a deteriorating global outlook, rising trade risks, and financial market volatility.

“Powell did not provide any guidance on the extent and timing of future rate cuts.”

We expect the Fed will lower the policy rate by another 25 basis points this year and once more in 2020. A cut could come as soon as September or October 2019. Still, we believe that even a combined 50-basis-point cut may not be sufficient to normalize the yield curve given the interaction between the Treasury yield curve, risky assets, and the global economy. If the 10-year Treasury bond yield stabilizes above 2%, a third 25-basis-point cut would normalize the curve. We believe that a positively sloping yield curve is important for the smooth functioning of financial markets, which are essentially the transmission mechanisms of monetary policy.

A preemptive move that raises questions

The U.S. labor market remains strong, and various measures of inflation expectations remain low but stable. Still, the Fed is worried that weaker global growth and trade tensions are affecting domestic business spending. Powell described the recent rate move as a mid-cycle adjustment to policy, or a so-called “insurance cut." Central banks use this phrase to describe monetary policy easing intended to counter potential risks to the economic outlook. But, do such risks exist in this case?

The first rate cut is almost never a recession-fighting cut. Whether this reduction will be the start of a full cutting cycle or end up being an insurance cut will depend on how the global economy evolves.

Possible scenarios for global economic growth

As such, we outline three possible scenarios for the global economy. The most likely outcome is that global growth will stabilize at low, but positive, levels. In addition to the July cut, the Fed may lower rates one or two more times by 25 basis points each. This is the insurance-cut scenario. The rates market had been pricing in up to 75 basis points of additional easing. Under this growth scenario, Treasury rates will back up a bit and risky assets will become vulnerable. While valuations are not as stretched as in late 2018, risky assets may have to adjust to slightly higher rates. The United States will continue to offer the highest rates among major economies. This will be positive for the dollar.

In the second scenario, global activity will deteriorate and drive the United States toward a recession. There will also be stresses to financial markets. This can quickly turn into a full-blown cutting cycle, and the Fed will likely reduce the policy rate toward zero. While this is not our base case scenario, it is a probability given weak global activity and trade tensions. If this scenario plays out, there will be high levels of volatility in risky assets, along with a rally in Treasury bonds and other risk-free rate markets. The dollar will appreciate because of its safe-haven status.

The third scenario will be the reacceleration in global growth. While growth may pick up at the end of 2019, sustaining higher levels of growth may be difficult without major stimulus from China and/or an end to trade tensions. We do not expect the Fed to restart the hiking cycle under this scenario. The U.S. yield curve will steepen, and risky assets are likely to perform better. U.S. growth may accelerate as the global economy expands at a faster rate. The dollar will likely weaken.

We anticipate growth indicators in coming weeks and months will show that the first scenario is emerging, and that the Fed is making insurance cuts to interest rates. We are keeping an active eye on risk assets in the portfolios, while also looking for any signs that the less-likely scenarios might become more probable. In this regard, President Trump’s threats to impose new tariffs on China in September has raised the probability of the second scenario unfolding.

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