In May, we wrote about the US Federal Reserve’s (Fed) evolving policymaking framework as it considers a shift to average inflation targeting. This new framework would allow the Fed to focus on urging average inflation toward its mandated target of 2%. The market set out to test the Fed as inflation trended lower in early 2019, after peaking in 2018.1 As inflation headed lower, bond markets began pricing rate cuts in March, even before the escalation of trade tensions.
In fact, the front end of the yield curve inverted in March, while the long end remained steep.2 We believe this price action is important because the curve tells a story. The front end of the curve (the three-month to one-year part of the Treasury curve) inverted as cuts were priced into bond markets. Further along the curve, the two-year to 10-year portion flattened but has not yet inverted year-to-date. Markets began to price rate cuts at the front end of the curve without a recession indicated by the longer end of the curve. This price action occurred amid a relatively small downgrade in growth expectations but softer inflation.3
While trade tensions, and the extent that they feed through to growth, have certainly played a role in this market pricing (three cuts for 2019), and matter to the Fed, this is not the whole picture. The June Fed meeting made this clear; trade was not the focus, although uncertainties were acknowledged. Instead, Fed Chairman Jerome Powell focused on the Fed’s commitment to extending the economic cycle, defined as a strong labor market and symmetrical path of inflation around 2%. The economic projections of the Federal Open Market Committee (FOMC), the so-called “dot plot,” implied lower inflation in 2019, and eight members projected one or two cuts. While the dot plot does not reflect the view of the committee, it may suggest that individual Fed members are shifting toward this new framework, foreseeing rate cuts amid stable growth but lower inflation.
We noted a similar tone (although with more mention of trade concerns) in the recent FOMC minutes and Powell’s testimony before Congress. The minutes suggested that many participants believe near-term rate cuts are appropriate if uncertainty continues to weigh on the economic outlook and inflation risks are skewed to the downside. Powell noted both growth uncertainty and muted inflation in his testimony, stating that inflation has softened year-to-date, while manufacturing and business investment has slowed, likely due to uncertainty over trade and global growth. In general, Powell’s communication has remained steady despite a de-escalation in US-China trade negotiations and a solid June jobs report.4
What can we expect from July’s Fed meeting?
As we approach the July 30-31 Fed meeting (at which a rate cut is fully priced by the market), the Fed has a tough assignment ahead. Either the Fed needs to deliver a rate cut in the face of potentially healthy market sentiment (if current price action continues), or it disappoints by delivering no cut while seeking to convince the market that it is committed to the new framework. Communication will be key. We believe the Fed will cut in July unless the economic data surprise to the upside. Our analysis points to a slowdown in growth, partly due to trade uncertainty (slowing investment), but also due to late-cycle conditions (slowing consumer spending). Poorer growth prospects and lackluster inflation will likely prompt the Fed to cut in July. Going forward, we do not expect a significant deterioration in the data but future rate cuts are not off the table, especially since seven of the eight FOMC members who are projecting rate cuts expect two in 2019.
This outcome would be positive for credit bonds, in our view, as slowing (but not recessionary) growth combined with a responsive Fed should support risk assets. We continue to exercise caution, however, as uncertainty, especially trade negotiations, could cause volatility in markets.
1 Source: Bureau of Labor Statistics, July 31, 2018
2 Source: Bloomberg, L.P., March 20, 2019
3 Source: Bloomberg, Jan. 1, 2019 through July 10, 2019
4 Source: Bureau of Labor Statistics, June 30, 2019
Blog header image: Shiro Hatori / Unsplash.com
The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.
The opinions referenced above are as of July 18, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.