Fed rhetoric lifts rate cut hopes

Thought of the day

by Chief Investment Office 19 Jul 2019

Dovish comments from Fed officials yesterday increased market confidence that the US central bank will act pre-emptively to protect growth. New York Fed President John Williams said "it's better to take preventative measures than to wait for disaster to unfold," while Fed vice-chair Richard Clarida suggested that rate cuts were needed to address rising economic risks. The comments pushed US yields lower, with a 3.5 basis points (bps) fall in the 10-year and a 6bps decline in the 2-year tenor. Markets are now priced for a roughly 45% chance that the Fed cuts by as much as half a percent at its 31 July meeting.

Further talk of an insurance rate cut reinforces our view that we are headed for a period in which rates are lower for longer than seemed likely at the start of this year. This backdrop increases the appeal of carry strategies. We see good value in US dollar emerging market sovereign bonds. In our FX strategy, we overweight a basket of equally-weighted high-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars).

But the market is still exaggerating the most likely scale of Fed rate cuts, in our view, by pricing in close to 100bps of easing over the next 12 months.

  • US economic data remains solid. Non-farm payrolls for June showed a surprisingly rapid pace of job creation, at 224,000 for the month. Unemployment is at multi-decade lows, and the number of job vacancies exceeds the number of jobless by around 1.3 million – signaling demand for labor remains strong.
  • Inflation is not worryingly low. The Fed has downgraded its PCE inflation forecast for the year to 1.5% from 1.8%. That gives scope for easing. However, there has been recent signs of a pick-up. The core Consumer Price Index rose 2.1% in June, boosted by strong increases for apparel, used cars, and household furnishings.

As such, it remains possible that the market will be disappointed by the pace of Fed easing, in our view. As a result, we are underweight in short- to immediate government bonds versus cash, and focus on carry strategies rather than aggressively increasing equity exposure.

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