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Investment outlook

Fed cuts once…twice…three times, then maybe

Brian Nick
Chief Investment Strategist
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The Federal Reserve reduced its target interest rate once again. It has done so three times since July, as signs continue to point to weakness in the global economy and persistent uncertainty on trade policy. Today’s rate cut was expected, but it’s still unclear what — or when — the Fed’s next move will be.

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What happened?

The Federal Reserve (Fed) followed up cuts in July and September with a 25 basis point (bps) reduction in October. The federal funds rate target range is now 1.50% − 1.75%. Futures markets had already incorporated this rate cut into pricing, with the implied probability rising above 95% in the past few days from just 66% immediately following the last meeting. There were two dissents from the decision, both from regional Fed presidents who would have preferred to keep rates unchanged.

The statement released after the meeting removed a key promise that the Fed would “act as appropriate to sustain the expansion.” This phrase had been seen in prior statements as a tacit promise that more cuts were coming. Its absence from the October statement indicates that the Fed may no longer believe further cuts are necessary.

In his press conference, Chair Powell reinforced this impression, saying that monetary policy is “in a good place” and that the current level of rates is “likely to remain appropriate” if conditions unfold as the Fed expects. This means a December cut is only likely if incoming data greatly disappoints.

What comes next?

The October cut was considered a fait accompli, given worsening U.S. manufacturing data and weaker job creation in recent months. But the path from here is far less certain. Coming into the meeting, markets were pricing in just a 31% chance of another rate cut at the December 11 meeting and a 56% chance of a cut by the end of first quarter 2020. Those odds fell to 20% and 46%, respectively, before the end of Powell’s remarks, which were perceived to indicate the Fed won’t cut rates further for now.

History may provide some perspective on the Fed’s apparent decision to stop after three cuts. We have only two recent examples of “mid-cycle adjustments,” periods in which the Fed has cut rates in the middle of an economic expansion: 1995 and 1998. In both years, the Fed cut three times before ultimately raising rates again after a pause. While today’s Fed will not necessarily be held hostage to the actions of prior ones should conditions worsen, the symmetry of the three-cut adjustment may be attractive if it makes the transition to a “pause” simpler to communicate.

Our base case coming into the meeting was that the October cut would be the Fed’s last, at least for a while. Barring a deterioration of economic data or an unexpected increase in tariffs, we maintain that view.

How do markets normally behave when easing cycles end?

We know from recent experience that financial markets often react with alarm to hawkish — or, more accurately, less dovish — turns in monetary policy. Investors may recall the “taper tantrum” in 2013, when stocks briefly swooned and rates surged as the Fed hinted it would end its long-standing asset purchase program. An end to this year’s short easing cycle may not be as monumental as the end of quantitative easing. Nevertheless, we are braced for higher equity and fixed income market volatility through the end of the year. Adding to this expectation is the prospect of further policy uncertainty. Another tranche of U.S. tariffs on Chinese imports is set to go into effect on December 15, and the U.K. will hold a pivotal general election on December 12. As if that weren’t enough, a disruptive U.S. government shutdown later this year cannot be ruled out.

The market’s reaction to the statement and Powell’s comments was fairly muted. The market-implied odds of a December rate cut, which were already below 50% coming into the meeting, fell further. Stock prices and long-term rates barely budged.

Meanwhile, on the other side of the Atlantic...

While Jay Powell tried to prepare markets for a transition from an easing cycle to a pause, the European Central Bank (ECB) underwent a leadership transition. Christine Lagarde, former head of the International Monetary Fund (IMF), will take the reins from Mario Draghi at the end of this week. Draghi’s eight years at the ECB’s helm were marked by aggressive balance sheet expansion and an experiment — active to this day — with negative interest rate policy to combat stubbornly weak growth and inflation on the continent.

Despite clear divisions at the ECB about the efficacy of Draghi’s policies, Lagarde represents a continuity of dovish leadership. As French Finance Minister during the global financial crisis and managing director of the IMF, Lagarde was often an outspoken voice for proactive and energetic government policy to provide economic stimulus and preserve market confidence. Notably, she opposed the Fed’s decision to begin raising interest rates in 2015 during Janet Yellen’s tenure.

Markets currently do not expect the ECB to raise interest rates back to positive territory until the mid-2020s, and the current quantitative easing policy seems likely to continue at least until eurozone growth and inflation return to less anemic levels. This, in turn, will pressure the Fed to keep interest rates low lest it further widen the gap between U.S. and international interest rates. This has historically pushed the U.S. dollar higher and destabilized global financial markets, as it did as recently as late-2018.

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Endnotes
Sources

Federal Reserve Statement, October 2019.
Bloomberg.

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Glossary

A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.

The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

A word on risk
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