Taking Back Control

It was a dramatic night last night as the Fed cut interest rates by 25bps, the first cut since December 2008, along with the premature ending to the balance sheet run off – however markets hardly moved!

The greatest drama to the cut was the entertainment value of more Powell bashing tweets from the President.

News coverage of the decision will be exhaustive, but a couple of points we were discussing last night and on the desk this morning were that Chairman Powell seemed reluctant over the move and with 2 regional Fed dissenters future meetings (next one on  18th of September) will potentially hold even more interest from markets. Currently there is a 62% probability of a further cut being priced in for September.

By deeming the move a ‘mid cycle adjustment to policy’ and not ‘the beginning of a lengthy cutting cycle’, the Fed is uncommitted to any future move which in all reality is probably optimal, if less immediately newsworthy. The Fed has essentially told the market it remains data dependent. There was also an emphasis on weak international growth and the effects of trade disputes.

What does this mean for Fixed Income investors? The main take home is that markets will have to up their attention to economic and market data over the coming months. The Fed took back some control of monetary policy last night by not providing the dovish guidance expected.

We have written in the past about the recession predictive powers of an inverted 2/10 yield curve and note that this almost reached single digits during the press conference, though is currently trading at 15bps. The 2/10 curve got to a low of 8bps last year and our feeling is that there are still significant events required to actually invert the curve; however we will be keeping an eye on this.

The $ will no doubt maintain its steady appreciation, another frustration for President Trump. For overseas buyers of $ assets however, it is a welcome reduction in hedging costs.

An elongated cycle is ultimately good for investors in the short to medium term, and it is still entirely possible that the next recession is more technical than a full blown dramatic contraction in the economy.  Moreover, the Fed does have further ability to accommodate that elongation objective. That said markets clearly have the ability to be volatile, and it is not impossible that we experience the ‘policy error’ fears that resulted in the sell-off experienced in the last quarter of 2018. In broad terms our stance on US Treasuries remains that yields should remain underpinned with the Fed now holding an easing bias. We see most value still at the front end of the curve with 2 year yields looking optically too high at 1.90, but we also feel safe holding the longer end which we believe will provide more protection for market volatility without the worry of yields gapping higher as they did for much of 2018.