Three Cuts and You’re Out?

Monthly Commentary

November 14, 2019

The Federal Open Market Committee cut its policy rate in October by 25 basis points (bps) for the third time this year and the target band for Fed Funds was adjusted lower to 1.75% - 1.50%. As the rate cut was largely expected by the market, the focus quickly turned to a few key phrases in the ensuing press release which appeared to signal that this month’s cut was likely the last of the “mid-cycle” adjustments to which Fed Chair Powell had previously alluded. The phrase “act as appropriate” with respect to the Fed’s stance on monetary policy was removed and replaced with “assess the appropriate path,” which most pundits interpreted as implying that after three cuts at its policy rate, the Fed was indeed “out” and no longer biased towards easing as it had been earlier in the year. The Fed’s overall assessment of the economy was mostly unchanged from the previous meeting as it appears content to wait and assess the lagged impact of its past cuts on the broader economy. Without providing any forward guidance on the future path of rates, the Fed appears to truly be in a data dependent stance for now.

During the post-meeting press conference, Fed Chair Powell reaffirmed the message from the press release by stating numerous times that the economy was in a “good place” and highlighting the strength of the economy’s consumer-facing segments, which remained resilient on the back of a strong labor market. He indicated that it would take a “material” change in the Fed’s outlook to warrant another cut and pointed to downside risks that, although still unresolved, have greatly moderated (Phase 1 trade deal with China in the works, immediate implementation of tariffs postponed and a non-negotiated Brexit seemingly off the table). Interestingly however, Powell flatly stated that a resolution to trade tensions would also not necessarily be a precursor to a rate hike, highlighting that the Fed’s primary focus remains on the domestic economy and its dual mandate. Instead, Powell suggested that it would take a sustained move in the Fed’s preferred measure of inflation (Core PCE) above its 2% target to warrant a rate hike.

2% Core PCE - Can We Get There?

Source: Bloomberg

The immediate Treasury market reaction to the FOMC decision was a flatter curve given the Fed’s signal that it is done cutting rates and is unlikely to meet the market’s expectations for easing in 2020. Interestingly however, the expected flattening after the “hawkish” cut was led by the 30yr point with the 2yr/30yr curve flattening as much as 7 bps before closing 4 bps flatter with the S&P 500 managing a small gain. As expected, the odds of a December cut similarly plummeted falling to 20% from 80% in the immediate aftermath of the press conference. The bar to hike rates appears high given core PCE’s inability to hit/remain above the Fed’s 2% target. Meanwhile, the Fed’s vow to respond to any “material” shift in the economic landscape likely lowers the bar to cut again. Given the low absolute level of the Fed Funds rate, this could well mean that the next cut in the face of sustained economic weakness will be “material” as well (e.g., 50 bps) especially given signs of late cycle dynamics within parts of the lower-tier credit markets.

Earlier in the month, the Fed continued to address and re-address the fallout from the previous month’s spike in repo rates. With 10% secured funding costs still fresh in their minds, the Fed was proactively attempting to get ahead of any potential volatility in secured funding markets at October month-end with an eye towards year-end as well. In addition to (twice) extending and increasing the sizes ($120bln overnight, $45bln term) of its Temporary Open Market Operations (TOMO) into at least January 2020, the NY Fed also announced a program to outright buy Treasury bills (starting at $60bln/month into 2Q2020) in the open market to add reserves back into the system. The Fed went to great lengths in the communication of this Treasury bill program (formally known as “reserve management purchases”) to disassociate it from a QE program. In addition to announcing the program on a separate day from the FOMC meeting, it also issued a supplementary note detailing that the program was purposely focused on short duration assets like bills as to have “little if any effect on longer term interest rates, broader financial conditions or the overall stance of monetary policy.” To be fair, although the announcement of the bill buying program sparked some “is it QE or not” debate in the market, the Fed did allude to the fact back in March that at some point it would begin increasing securities holdings to maintain an “appropriate level of reserves.” After realizing ex post that this appropriate level of reserves was at least the $1.5trln level from late-August, Powell quipped that the time to add those reserves back into the system was “now upon us.”

Take-Up at Fed TOMO

Source: BMO CM, FRBNY

During the post-FOMC press conference, Powell was admittedly perplexed as to why banks did not deploy their reserves into the repo markets in mid-September despite the very favorable economics. He acknowledged that perhaps some regulation with respect to intraday liquidity would likely need to be re-addressed in some form. This could, in theory, allow reserves to flow more freely within the financial system and make their way down to more end users. As the debate around reserve management purchases being QE or not raged on in the background, the combination of the Treasury bill buys along with the on-going TOMOs appeared to have stabilized repo markets for now with October month-end, for example, coming and going without any dislocations around funding markets.

With the secured funding markets largely placated for now, thanks to the Fed’s balance sheet, the market will revert to wait-and-see mode with respect to monetary policy going forward. As we head into year-end, the Fed appears satisfied with its work as it waits for the cumulative effect of past cuts to make its way through the economy. Again, the bar to raise rates has clearly been placed higher, given the inability of the Fed’s preferred inflation metric to consistently hit its 2% target over the past 10 years. Therefore, with Treasury yields likely capped to the upside and the Fed on high alert to mitigate downside risks to the economy, the asymmetric Fed response function appears alive and well. Ultimately, it remains to be seen if the Fed does step back to the plate for another “cut” at the Fed Funds rate, especially into the later innings of the domestic credit cycle. For now, the Fed appears content to watch from the dugout as steeper curves and overall easier financial conditions have temporarily calmed recessionary fears.

3mo/10yr Treasury Spread

Source: Bloomberg

Source: Bloomberg

 

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