The Fed is going to do what it takes to extend this economic expansion
The US Federal Reserve (Fed) cut rates by 25 basis points on 31 July. The question for investors is whether this is an insurance rate cut similar to Fed easing in 1995 or 1998 versus a pre-recession rate cut as happened during the Global Financial Crisis.
- The front-end rates market reaction is telling. If after the cut, markets price in even more easing over the next year and a half, historically that has been a negative signal for the economy. In the immediate aftermath of the cut, the rates market is indeed demanding additional easing—this has been exacerbated by the recent escalation in trade tensions between the US and China. We believe that the Fed will likely have to be more aggressive in easing policy in order to get ahead of the curve.
- We watch key economic data around labor markets and consumption. In this category, consumer confidence is strong, almost at cycle highs. Initial jobless claims are at 50-year lows.
- Financial conditions have eased since December, 10-year yields have declined, mortgage rates are down and corporate credit spreads have come in. This is supportive for the consumer and US businesses.
- We haven't seen recessions in the past without the fed funds rate surpassing nominal GDP growth annualized. We still have a very healthy gap from where the fed funds rate is versus where growth is coming in.
- We believe that the biggest risk by far is further escalation in the US-China trade war, which could further undermine business confidence and tighten financial conditions. Manufacturing globally has moved into contraction territory. Thankfully, services make up the bulk of developed market economies, and services have remained strong. In the US manufacturing is only 10% of US GDP.
- Historically, when the Fed cuts and the economy doesn't fall into recession, stocks, bond yields and the dollar rise. In a recessionary environment the opposite is true. We remain in the no recession camp, but risks are rising.
We recently turn tactically little bit more cautious on risk assets.
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