Positioning ahead of expected Fed cut(s)

By: AGF Fixed Income Team • July 1, 2019 • Product Insights

From a firmly restrictive stance to begin 2019 and ‘patient and pragmatic’ through the spring, 8 of 17 Fed voting members are now calling for at least one rate cut before year-end1 (in fact seven voting members project two cuts) upon reignited trade concerns and effectively non-existent inflationary pressures. In comments made at their June policy meeting, the Fed offered several strong clues that a rate cut may come as soon as July, stating “uncertainties about this outlook have increased…and (the Fed) will act as appropriate”. Odds of a July rate cut have increased to 100% following the statement and 75bps of cuts are priced in over the next three meetings1.

 

Where do we go from here?

Market Implications: An injection of stimulus into the economy at this point in the cycle should naturally provide a lift, but interestingly, the extent of subsequent equity market rallies depends heavily on whether a recession begins within a year of the first cut. Work from Ned Davis Research with data dating back 100 years shows ‘insurance’ cuts, or those proactively implemented while economic fundamentals are still relatively healthy, have enjoyed more than double the returns to those of ‘emergency’ cuts where a recession is imminent.

Fed Rate Cuts

Source: Ned Davis Research, June 2019 


 

To be sure, a July cut is not yet a foregone conclusion and the case presented could very well be pushed to a later date, especially considering inconsistent messaging from the Fed thus far into Governor Powell’s tenure.


Political unknowns should also be considered. A positive development relating to U.S.-China trade negotiations could spur a risk-on rally of its own and delay the need for lower rates in July. President Trump has also been very critical of Governor Powell in calling for easier monetary conditions from the Fed. In response, perhaps the Fed will delay, reduce the amount of easing or not cut at all to prove their independence. The likelihood of these scenarios are difficult to project, but all need to be considered.


Be cautious: In the fixed income team’s view, Fed stimulus playing out exactly as scripted by current market forecasts seems improbable. ‘Insurance’ cuts may be overdone in the short-term, which introduces risk of disappointment should the Fed maintain policy rates at current levels or ease less than the 75bps markets have priced in. By the same token, fully priced in stimulus suggests to us that much of the expected upside may have already been realized; case in point, the S&P 500 reached all-time highs in late-June on speculation of a potential cut2.


How we’re positioned: While the extent Fed cuts is unknown, market expectations of easier financial conditions should reflect positively on corporate credit and pressure the U.S. dollar in the near-term. As a result, we favour high yield bonds and emerging market debt among fixed income categories for the quarter ahead. Particularly within EM, we prefer local denominated issues, provided trade negotiations do not unravel further. As discussed, with cuts already priced in, we do not expect a significant reaction from rate-sensitive bonds and are neutral towards the category.

 

Conclusion

Throughout the first half of 2019, the financial market’s opinion of appropriate interest rate levels has differed significantly from U.S. Federal Reserve (Fed) projections. While markets wavered in fear of policy error, the Fed appeared on a clearly restrictive path, hiking rates as recently as December 20183.


Fast forward to today, however, and it appears the markets may have been heard. A lear acknowledgement from the Fed at their June meeting of anemic economic conditions (inflation) and other uncertainties (trade) suggests a rate cut should be expected sometime in the coming months barring an uptick in inflation and/or breakthrough in trade negotiations. Looking back at the past century of data, the last Fed hike of a tightening cycle is followed by a rate cut only eight months later, on average, so perhaps a summer rate cut would be right on time4.


Some level of easing should be positive for equity markets in general and credit-sensitive bonds in the nearterm, however we remind investors to consider further upside potential over the longer term considering what is already priced into the markets.

 


1 Source: Bloomberg, as of June 24, 2019
2 Bloomberg, as at June 21, 2019
3 U.S. Federal Reserve Board
4 Ned Davis Research, February 2019

Commentaries contained herein are provided as a general source of information based on information available as of June 24, 2019 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice. AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.
Published date: July 2, 2019
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