Following ‘Expected’ Rate Cut(s) – a Standoff Between Late Cycle Versus Global Contraction
Benjamin Lavine, CFA, CAIA
The U.S. Federal Reserve will meet this week and is expected to not change the Federal Funds Rate; however, Fed observers will focus on forward language and updates to ‘dot-plot’ forecasts on the trajectory of the Fed Funds Rate over the next couple of years. Most economists now expect the Fed to cut rates at the July meeting – an abrupt about-face from last October when many expected the Fed to continue to hike rates.
Several Fed officials and economists have attempted to connectd the current global economic malaise (pull-back in global trade flows and manufacturing sentiment) to the ongoing trade disputes between the U.S. and China, which appear to be dragging down economic activity, not just in their respective countries, but in Europe and Japan as well. World leaders will meet in Osaka for the G-20 summit later this month, and there are now concerns that U.S. President Trump will not meet with Chinese President Xi to offer the potential for a ‘positive reset’ in trade discussions.
Fed Funds futures are pricing in at least a 0.25% rate cut by the July meeting (Figure 1), with some calling for a 0.50% ‘insurance’ cut to head off a steeper slowdown. In addition, Fed Funds futures are now pricing in three rate cuts by year-end, so the bond market expects an aggressive response by the Fed to head off deflationary pressures.
Figure 1 – Fed Funds Futures Pricing in At Least Three Rate Cuts by Year-End
There seems to be little doubt that manufacturing sentiment (purchasing manager surveys) has slumped, with much of the recent weakness showing in Europe (namely, weaker Germany business confidence around global export orders – Figure 2).
Figure 2 – Europe Manufacturing Sentiment Slumps into Contraction
Global semiconductor sales have also dropped at magnitudes typically seen prior to major recessions (Figure 3).
Figure 3 – Global Semiconductor Sales Have Sharply Dropped
Even with the Fed on hold at this moment, the Fed’s tight stance relative to world central banks has driven investors away from negative yielding bonds in Europe and Japan to the safe haven of the U.S. dollar which has weighed on pro-cyclical signals such as industrial metals pricing (Figure 3).
Figure 3 – U.S. Dollar (DXY) Strength Weighs on Global Trade as Reflected in Industrial Metals Pricing
The broader debate concerns whether the timing of ‘expected’ rate cuts will be soon enough to counter a global slowdown, which is primarily reflected in global manufacturing and business sentiment rather than the global consumer (global retail sales trends still remain elevated). The conventional argument concerning Fed rate cuts is that they tend to occur too late in order to stem economic contraction. However, if the Fed is early enough (a close analogy is the 1995-96 rate cut period under former Fed Reserve Chairperson Alan Greenspan), then those rate cuts can act help arrest an extended slowdown. With 2-3 rate cuts, the markets hope that the Fed can stop the advance of oncoming deflationary forces.
At least that’s the hope. Very few are concerned that the Fed will fall behind the curve on inflation. Inflation expectations, priced between nominal U.S. Treasuries and TIPS, are tending lower, having dropped below 2% (Figure 4).
Figure 4 – Inflation Expectations (Nominal U.S. Treasuries vs TIPS) Trending Lower
At least inflation expectations remain positive in the U.S., whereas Europe is close to the precipice of falling back into deflation (Figure 5).
Figure 5 – Inflation Expectations Collapse Across Europe
Partially offsetting worries around a global recession, corporate credit markets and the U.S. term structure are pricing in the prospects of lower short-term interest rates (Figure 6). U.S. credit spreads are wider versus their recent lows but have not blown out like they did in 4Q2018 over concerns that the Fed would remain stubbornly tight. The U.S. term structure is inverted (short rates higher than intermediate rates) out to the intermediate part of the curve, but the 2-10 year term structure remains positive and has steepened out to the mid-20 basis point range from the mid-teens. The positive 2-10 year term spread might also suggest that the bond market is expecting enough of an economic slowdown to warrant easier central bank interest rate policies but that the overall economic environment still remains positive (slowdown but no recession).
Figure 6 – High Yield Credit Spreads Below 4Q2018 Panic Levels While 2-10 Year Treasury Term Structure Remains Positive – Both Imply Easier Central Bank Policies and Slowdown/Not Recession
The Fed backtracking from its 2016-2018 rate hike schedule could be seen as confirmation that the global economic slump will spill over into contraction, but Fed rate cuts and a weaker dollar should also provide economic tailwinds as well in the form of higher liquidity and easier financial conditions. European financial conditions have tightened but not so much to indicate systemic stress while China’s credit impulse continues to improve from its 4Q2019 depths (Figure 6).
Figure 7 – European Financial Conditions and China Credit Impulse Should Benefit from Easier U.S. Monetary Policy
So, assuming the Fed cuts rates at the July meeting (it doesn’t matter if it’s 0.25% or 0.50% – what matters is forward language), what next? U.S. / China trade relations remain the large overhang over global economic sentiment and trade-flows with secondary concerns over the state of Brexit (likely some form before the October deadline) and the Middle East (Iran, Turkey). Investors are facing the prospects of a stand-off – easier financial conditions (lower interest rates, narrower credit spreads) and positive global consumption facing off against deflationary pressures stemming from a slowdown in global trade, slumping manufacturing sentiment and the prospects of a Cold Trade War between the U.S. and China.
Will the U.S. finally see the end of its business cycle with some raising the odds of a 2020 recession? A resolution to U.S. / China trade stand-off would certainly lower these odds, but markets will need to grapple with what comes next once the Fed delivers on lower interest rates.
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By: Benjamin Lavine