Equities rallied and bond yields fell after Wednesday's testimony by Federal Reserve Chair Jay Powell and minutes from the 19 June FOMC meeting supported our view that the Fed will cut rates at its next meeting on 31 July. In fact, Powell's prepared remarks, released 90 minutes before his testimony began, were so dovish that markets priced in an increased probability that the Fed would cut by 50 instead of 25 basis points (bps).
With US equity markets near record highs and the unemployment rate near a 50-year low, this would appear to be a strange time for the Fed to be considering rate cuts. However, we see three main reasons for the Fed to cut:
- Inflation: The Fed's preferred inflation measure has fallen significantly below its 2% target. Further, inflation expectations have dropped to a level that indicates market skepticism over the Fed's ability to hit its target in the future. A rate cut under current circumstances would send a strong signal to the market that, after years of missing to the downside, the Fed is serious about getting inflation up to the target.
- Downside risks: While the Fed expects the economy to grow at around a 2% pace, it is worried about downside risks. Global growth has slowed. The various trade disputes and tariff hikes have created uncertainty that makes it more difficult for businesses to commit to investment. There is also a risk of another government shutdown or sharp cut in government spending after the fiscal year ends on 30 September.
- Inverted yield curve: 10-year Treasury yields are below the 3-month rate. Historically this has been one of the most reliable signals that a recession is on the way. While our view remains that "this time will be different," the minutes showed that several FOMC participants are concerned that history could repeat itself. With the federal funds rate currently at 2.38% and 10-year Treasury yields at 2.04%, cutting rates by 50bps should be enough to get the yield curve out of inversion. The market is pricing in 100bps of cuts by the end of 2020. In our view, cuts of that magnitude are unlikely, requiring further deterioration in the economic data or a significant escalation of the trade disputes.
With the Fed looking almost certain to cut rates in the coming weeks, it is important to position portfolios properly regardless of the outcome. We continue to recommend that investors remain overweight equities with a regionally selective approach. We think markets have gone too far in pricing rate cuts, and prefer stocks and cash over shorter-maturity US government bonds. In the near term, given downside risks, we would also recommend countercyclical positions.
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