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, âbut we still have yet to see any material deterioration in economic fundamentals,â said Greg McBride, chief financial analyst at Bankrate.com. âAbsent 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,â he added. âIt is literally âeasier saidâ by Powell âthan doneâ by FOMC participants in the updated economic projections."
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âThe Fed would disappoint markets if they project a calm confidence in the economy,â McBride said, âbut thatâs just what they should do to avoid being whipsawed by the economic data from one month to the next.â
The Fed has preached patience, and Ryan McQuilkin, managing director and head of fixed Income at Boston Private, said policy makers probably âwill 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.â
The main decision is âwhether it's prudent to proactively cut ratesâ although data show âonly a modest deterioration,â he said. The Fed needs to signal a willingness to intervene if needed, âwhile at the same time expressing confidence in the economic outlook going forward.â
The yield curve inversion is making some bond buyers apathetic. It's hard to get excited about buying bonds at current levels,â McQuilkin said, âespecially 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.â
If the Fed disappoints the market, he said, that âcould 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.â
Josh Siegel, CEO and managing partner at StoneCastle Partners, agreed, saying, âNearly all metrics would support maintaining the current rate, suggesting neither a cut nor an increase.â Global issues and politics have the potential to âslow the global economy but it hasnât materialized in any significant form as of yet,â Siegel said. In his opinion, the Fed will not cut rates before the economy slows significantly.
In fact, Siegel expects âa tight range on the dot plot, with general consensus on maintaining rates constant, with two or three outliers.â
Indeed, the key to market reaction is âhow the Fed balances what the market wants with what they are willing to message,â said Brian Rehling, co-head of global fixed income strategy at Wells Fargo Investment Institute. âI think the market will be disappointed in the magnitude of the changes,â he said. âI do not expect a material revision lower in âdotsâ or message. It is likely that the Fed will wait for more data before committing to a rate cut.â
The Fed is in a precarious position, according to Craig Kirsner, president at Stuart Estate Planning Wealth Advisors, with âproactive interventions that have created the expectation game.â
With less than half the rate-cut ammunition than it had in the past two cycles, the Fed âwould be foolish to cut rates here,â he said, âbut who knows, as the current Fed jumps as soon as the market so much as sneezes."
âBut thatâs the problem for the Fed here, the market is not sneezing,â Kirsner said, âitâs almost at all-time highs on the expectation of rate cuts.â
And inverted yield curves âaren't good omens.â A rate cut would show the markets the Fed believes âthe economy isn't as strong as they'd like us to believe.â
While a rate cut will eventually be needed, John Dunham president of John Dunham & Associates, said he expects the Fed to âlikely stay in a holding pattern until after the June and maybe even the July jobs report.â
With Treasury yields âjust over 2%,â they are âlower than the target Federal Funds rate. Heck even the 30-year yield is almost below the current target rate,â Dunham said.
He expects âdemand will pick up after the second quarter, which was hurt by unexpected tax increases and decreased refunds.â
"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 whatâs 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 âclearly 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 inâ the last half of the year, according to Ed Al-Hussainy, senior rates and currency analyst at Columbia Threadneedle Investments. He sees a âprecautionary easing cycleâ of 75 to 100 basis points.
The Fed has been backed âinto a cornerâ by president Trumpâs ârancorous trade policy with China," said Robert Johnson, CEO and chair of Economic Index Associates. In addition, âthe presidentâs 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.â And while the FOMC could make an insurance cut at some point, âthe mitigating factor is the Fed wants to be seen as independent of political pressure.â
If you look at the yield curve, the inversion in the three-month to two-year suggests a âFed rate cut is warranted and coming,â 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 ârelatively steepâ 10-year to 30-year curve allows âgrowth and inflation to stabilize longer-term, albeit at a lower levels.â
Diczok says Fed projections have been wrong, with inflation below 2% in each calendar year since 2008. âWhich is transitory?â he asks, âThe drop to 1.5% or the rise to 2%?â
BNP Paribas expects the Fed will acknowledge increasing downside risks, with âseveral participantsâ penciling âin lower rates by year-endâ 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.