While the markets are pricing in two or three interest rate cuts this year, doubters remain.
The Federal Open Market Committee meets on June 18 and 19, with a new Summary of Economic Projections to be released, and, of course, a press conference with Chair Jerome Powell.
When the panel last convened, the trade issue had yet to evolve, “but we still have yet to see any material deterioration in economic fundamentals,” said Greg McBride, chief financial analyst at Bankrate.com. “Absent that, how do FOMC participants change the dot plot to forecast a reduction in interest rates, which no one did going out through 2021 when last released in March?"
Although the markets are looking for rate cuts, "it will be a delicate dance for the Fed to pivot in that direction without forecasting notably lower economic growth and higher unemployment than they had in March,” he added. “It is literally ‘easier said’ by Powell ‘than done’ by FOMC participants in the updated economic projections."
“The Fed would disappoint markets if they project a calm confidence in the economy,” McBride said, “but that’s just what they should do to avoid being whipsawed by the economic data from one month to the next.”
The Fed has preached patience, and Ryan McQuilkin, managing director and head of fixed Income at Boston Private, said policy makers probably “will apply that same patience when assessing rate cuts … and we don't think they will start down a rate-cutting path unless it's completely necessary.”
The main decision is “whether it's prudent to proactively cut rates” although data show “only a modest deterioration,” he said. The Fed needs to signal a willingness to intervene if needed, “while at the same time expressing confidence in the economic outlook going forward.”
The yield curve inversion is making some bond buyers apathetic. It's hard to get excited about buying bonds at current levels,” McQuilkin said, “especially when rates were almost a full percentage point higher only seven months ago. This is compounded in the municipal bond market where valuations are also historically rich. A flat curve from 0-5 years provides very little incentive to buy five-year maturity bonds when shorter maturity bonds offer similar yields.”
If the Fed disappoints the market, he said, that “could put upward pressure on front end yields, possibly inverting other parts of the yield curve, such as the much-watched two-year/10-year spread.”
Josh Siegel, CEO and managing partner at StoneCastle Partners, agreed, saying, “Nearly all metrics would support maintaining the current rate, suggesting neither a cut nor an increase.” Global issues and politics have the potential to “slow the global economy but it hasn’t materialized in any significant form as of yet,” Siegel said. In his opinion, the Fed will not cut rates before the economy slows significantly.
In fact, Siegel expects “a tight range on the dot plot, with general consensus on maintaining rates constant, with two or three outliers.”
Indeed, the key to market reaction is “how the Fed balances what the market wants with what they are willing to message,” said Brian Rehling, co-head of global fixed income strategy at Wells Fargo Investment Institute. “I think the market will be disappointed in the magnitude of the changes,” he said. “I do not expect a material revision lower in ‘dots’ or message. It is likely that the Fed will wait for more data before committing to a rate cut.”
The Fed is in a precarious position, according to Craig Kirsner, president at Stuart Estate Planning Wealth Advisors, with “proactive interventions that have created the expectation game.”
With less than half the rate-cut ammunition than it had in the past two cycles, the Fed “would be foolish to cut rates here,” he said, “but who knows, as the current Fed jumps as soon as the market so much as sneezes."
“But that’s the problem for the Fed here, the market is not sneezing,” Kirsner said, “it’s almost at all-time highs on the expectation of rate cuts.”
And inverted yield curves “aren't good omens.” A rate cut would show the markets the Fed believes “the economy isn't as strong as they'd like us to believe.”
While a rate cut will eventually be needed, John Dunham president of John Dunham & Associates, said he expects the Fed to “likely stay in a holding pattern until after the June and maybe even the July jobs report.”
With Treasury yields “just over 2%,” they are “lower than the target Federal Funds rate. Heck even the 30-year yield is almost below the current target rate,” Dunham said.
He expects “demand will pick up after the second quarter, which was hurt by unexpected tax increases and decreased refunds.”
"A combination of disappointing U.S. jobs and inflation data and concerns over trade deals has resulted in the market pricing in two to three cuts before the end of the year, and more next year," said Michael DePalma, portfolio manager of the High Yield ETF and managing director at MacKay Shields. "We believe this is premature and economic and financial conditions do not warrant cuts at this time."
DePalma said the Fed should "wait until financial conditions tighten significantly. This can happen in a variety of ways, stock prices falling, credit spreads much wider, big move down in economic outlook. If/when that happens they should cut big, 50-100bps on the first cut would have meaningful impact. You want the cuts to matter, you have to go beyond what’s priced in."
Of course, many market observers see some sign from the Fed that they will ease.
Dr. Michael Dooley, professor emeritus at University of California, Santa Cruz, expects the FOMC will “clearly signal a rate cut at the July meeting. The main driver for this move is their failure to push inflation up to their target at a time when they would welcome an overshoot of that target."
"The current growth/inflation/uncertainty conditions assessment of the Fed reaction function are consistent with starting an easing cycle in” the last half of the year, according to Ed Al-Hussainy, senior rates and currency analyst at Columbia Threadneedle Investments. He sees a “precautionary easing cycle” of 75 to 100 basis points.
The Fed has been backed “into a corner” by president Trump’s “rancorous trade policy with China," said Robert Johnson, CEO and chair of Economic Index Associates. In addition, “the president’s acrimonious comments regarding Powell and the Fed serve to set the Fed up to be the scapegoat should the U.S. economy fall into a recession.” And while the FOMC could make an insurance cut at some point, “the mitigating factor is the Fed wants to be seen as independent of political pressure.”
If you look at the yield curve, the inversion in the three-month to two-year suggests a “Fed rate cut is warranted and coming,” according to Matthew Diczok, head of CIO fixed income strategy, Merrill and Bank of America Private Bank. Flatness in the two-year to 10-year indicates no impending recession, while the “relatively steep” 10-year to 30-year curve allows “growth and inflation to stabilize longer-term, albeit at a lower levels.”
Diczok says Fed projections have been wrong, with inflation below 2% in each calendar year since 2008. “Which is transitory?” he asks, “The drop to 1.5% or the rise to 2%?”
BNP Paribas expects the Fed will acknowledge increasing downside risks, with “several participants” penciling “in lower rates by year-end” and rate cuts in July and September, said Daniel P. Ahn, BNP chief U.S. economist and head of markets 360 North America and team.
Economic data
Housing starts fell 0.9% in May to a seasonally adjusted annual rate of 1.269 million units as single-family housing declined, the Commerce Department said on Tuesday.
April's number was revised up to 1.281 million units from the initially reported 1.235 million.
Building permits were up 0.3% to 1.294 million units.
Economists polled by IFR Markets expected 1.240 million starts and 1.290 million permits.
Following a 26-point plunge in the Empire State Manufacturing Survey on Monday, The Federal Reserve Bank of New York reported the service sector also slumped. The June Business Leaders Survey's headline business activity index fell 15 points to 5.8, its lowest level since January.
