The Hawkish Rate Cut

Co-Head of Global Bonds Nick Maroutsos explains why a pause after today’s rate cut may make sense in the short term, but greater accommodation may be necessary over the long haul.

Key Takeaways

  • While the rate cut may be the headline, hints at a pause in accommodation is the real story as the Fed waits to see if recent steps, when combined with strong U.S. consumption and employment, catalyze economic growth.
  • We take a more cautious view, fearing that slowing global growth will leach into the U.S. economy and that barring a breakthrough in trade, risks to jobs and the consumer are to the downside.
  • The Fed’s move is favorable to risky assets, but bond investors should focus on “defensive credits” and be selective in their duration allocation, seeking regions with favorable risk/return dynamics.

Little in today’s Federal Reserve (Fed) decision to reduce its benchmark rate by 25 basis points (bps) surprised us. We believe the factors that have led to this year’s three rate cuts remain intact, but the timing was right for the Fed to tactically adjust its forward guidance by emphasizing that it is back in the “assessment” mode rather than the “act as appropriate” phase with regard to future economic developments. We interpret this shift as a fourth 2019 rate cut likely being off the table. Futures markets feel the same, as the predictions for an additional 25 bps rate cut in December fell in the wake of the Fed announcement.

Sticking to the Script

The Fed again highlighted the dichotomy between the U.S. and much of the rest of the world. In the former, consumption and employment data remain strong. Globally, weaker growth and the acute risks presented by slowing trade are still headwinds. While these factors were behind this year’s rate cuts, we suspect the Fed believes it has moved far enough for now and that it should allow lower rates to work their way through the economy before acting again. Consequently, we believe that the Fed will stand pat through the end of this year. Furthermore, a rhetorically more disciplined Chairman Jerome Powell likely wanted to send a signal that he would not be pushed around by markets as he was accused of being last December. As such, he reiterated the governing board’s confidence in pausing and that its recent activity in short-term lending markets was not a form of shadow quantitative easing.

A Welcoming Market

The market’s immediate reaction was one that we expected. Lower rates are favorable to growth assets, and consequently, U.S. stock indices rallied after the announcement. The Fed’s confidence in pausing also hinted at a perhaps less challenging macroeconomic backdrop, a view Chairman Powell asserted when he suggested risks were likely to the upside. By that token, the market may consider the pause as the lessening of near-term headwinds. The bond market also welcomed the rate cut, as yields fell across the U.S. Treasuries curve. This aligns with our view that owning duration is likely a good tactic at this time. We would, however, remind investors that not all duration is created equal, as certain regions may offer attractive yields relative to the U.S. and whose central banks are still firmly in rate-cutting mode.

Near-term Gain, Long-term Pain?

Despite the Fed’s likely prudent move in offering a balanced view of economic conditions, we have our concerns, especially over the longer term. We believe the diminishing returns of dovish monetary policy and the near absence of fiscal stimulus in developed markets will ultimately translate into even weaker growth and cooling investor sentiment. Similarly, barring a breakthrough in trade, and perhaps even then, slower global growth will eventually leach into the U.S. economy. In contrast with the Fed’s borderline rosy assessment, we fear that exceptionally low unemployment and a solid consumer likely means risk to these two factors is to the downside.

With this in mind, we are keeping with our longer-term view that the yield on 10-year Treasuries will eventually reach 1.0%. Informing our view is this more cautious U.S. outlook and the negative rates in other countries continuing to fuel demand for U.S. assets. While this may be favorable for duration, the universe of government bonds that don’t offer incredibly unfavorable price asymmetry is limited. Our caution extends to corporate credit. Lower rates should benefit corporate borrowers, but we believe the emphasis should be on “defensive credits”: companies with strong balance sheets, liquid issuance and the ability to generate income throughout the business cycle. Corporations that view low rates as carte blanche to operate business models incapable of consistently generating free cash flow should be avoided.