The Federal Reserve
(Fed) cut rates by 0.25% for the first time in over a decade,1 a
move largely expected by the market. Heading into the July Federal Open Market
Committee (FOMC) meeting, much of the debate was around whether or not the Fed
would deliver 25 or 50 basis points. However, we were focused on the statement
and Fed Chairman Jerome Powell’s press conference for further insight on future
policy. Future policy, or the Fed’s reaction function, is particularly important
as we navigate in an environment where we believe market pricing indicates more
cuts than our economic outlook would imply.2
Below, we lay out a framework
for thinking about possible outcomes
for rate cuts and markets. The Fed appears to be following
a new reaction function
centered on average inflation targeting. This framework would allow
the Fed to move inflation toward its mandated target
of 2%, and even allow it to fluctuate
above 2%, as long as inflation averages
2% over a given business cycle. The market has already tested the Fed; as inflation headed lower in early 2019,
bond markets began pricing
happened at the July meeting?
Today’s Fed statement
was balanced, noting solid job gains and consumption but soft business
investment and lackluster inflation. It further reiterated the FOMC is monitoring the economic outlook and will act as
appropriate to extend the current expansion.
In his press conference, Powell called this rate cut a
mid-cycle adjustment to combat current risks to the economic outlook, rather
than the start of a cutting cycle. He stated three main threats to the outlook that
the Fed has been monitoring since the start of the year and now justify a rate
global growth, trade policy developments and inflation running below target.
What can we expect in the months that follow?
In our view, the outcome
from this meeting further ratifies our expectation that the Fed is moving
toward a framework which monitors inflation more closely, despite a solid labor
market. Further, Powell made it clear that risks to US growth via the
manufacturing sector and trade developments are being monitored as well. So
what now? What should we expect in the ensuing months? How might the macro data
evolve, and what would different macroeconomic outcomes mean for Fed policy
and markets? Below, we
lay out four scenarios for trend growth and
inflation over a six-month horizon and their projected probabilities. We also provide
a framework for projecting the Fed’s reaction based on
its framework, and implications for risk asset
Macro scenarios and Fed reaction function
Table 1 highlights our base case: 2% trend growth and 2% trend inflation over the next six months.
Our base case scenario implies two Fed rate cuts in total, or one more in 2019, as shown in Table 2. This compares to the market’s current pricing of four cuts in total, or three more over the next year. According to our model, annual trend growth below 1.25% or inflation below 1.5% would imply a much larger number (10) of cuts. Boxes marked n/a represent rare scenarios that we believe are unlikely to occur in the near term.
What do these scenarios imply for asset performance? In Table 3, we forecast asset performance using our macro factor analysis framework. In the top left of Table 3, tighter financial conditions may cause risk assets to underperform. In the bottom right, low growth would likely cause risk assets to underperform. Our base case scenario (2% trend growth and inflation), suggests neutral performance of risk assets in the near term. However, if growth falls sharply (below 1.25%), or if inflation rises sharply (2.5%), we would expect risk assets to perform poorly.
In our base case of 2% trend growth
and inflation, we believe credit
investors can expect to collect coupons but price returns will likely be limited. In other words, if growth and inflation do not “break out” higher or
lower, the Fed should remain
responsive for the majority of 2019, but not cut aggressively. The red boxes in
Table 3 represent scenarios in which
the market perceives the Fed to be behind in its policy
action. This would
likely add volatility to markets as the probability of a policy error begins to increase.
We do not see evidence in the
underlying data to make a strong case for these
scenarios, but we continue to monitor these risks closely.
Source: Bloomberg, L.P. Data as of Dec. 16, 2008.
Source: Bloomberg, L.P. Data as of July 30, 2019.
Source: Bloomberg, L.P. Data as of March 12, 2019.
header image: Ferran Izquierdo-Alto Images / Stocksy.com