Curmi & Partners

One step closer to an 'insurance cut'

By Matthias Busuttil 

After assuming a dovish tone in January 2019 following a series of 9 rate hikes since December 2015, the US Federal Reserve (Fed) Chairman, Jerome Powell, has reinforced the commitment of the FED in the subsequent Federal Open Market Committee (FOMC) meetings held in March and April to maintain patience in assessing the need for a change in policy as economic developments unfold.

With the US economy still growing above most estimates of potential growth and unemployment rate remaining at very low levels, the rationale for the shift towards a dovish policy stance looks weak. US inflation has been relatively low compared to the Fed's symmetric target of 2%. However, the Fed has explained the weakness in inflation to be influenced by transient factors.

On the other hand, Mr Powell has been citing "cross currents" as the main downside risk factors to the Fed's aim to sustain economic growth and a strong job market with the view of stimulating price pressures. These mainly refer to the on-going trade negotiations and rising concerns of weak global economic growth.

Since the last policy meeting held between 30th April and 1st May, these cross currents have intensified. Adverse developments in the trade discussions with China have created heightened uncertainty while global growth indicators have broadly disappointed. These factors are impacting business confidence as market participants are increasingly eyeing a slowdown in the second half of the year.

In this environment, the market was right to increasingly predict the possibility of rate cuts in 2019 by the Fed. This was mainly evidenced by the declining Federal Funds Futures implied rates and a general downward movement in the US treasury yield curve - specifically the 2-year treasury yield has broken well below the short-term policy target range of 2.25% - 2.5% towards the end of May, to around 1.73% as at the time of writing. Inflation expectations have also deteriorated as seen in the narrowing differential between inflation-protected bonds and fixed-rate bonds - although this is an imperfect proxy.

 Therefore, despite the relatively strong economic fundamentals in the US, these factors are exposing concerns about the fragility of the growth path of the US economy while inflation expectations remain weak. When taking all of this into consideration, the motive for a softer forward guidance incorporating a rate cut or two becomes much more plausible. And this is exactly what Mr Powell delivered in his press conference on 19th June following the latest FOMC meeting.

To the detriment of those betting on an imminent cut, the FOMC has decided to leave interest rates unchanged in June. However, Mr Powell's press conference was delivered with significantly more accommodative tone saying that FOMC members indicated that "the case for additional accommodation has strengthened" since the last meeting. In fact, FOMC members have indicated what they deem to be the appropriate policy rate for 2019 to be lower on average than that indicated in the March meeting.

Markets are now expecting the next action to be an "insurance cut" in July. The term "insurance cut" refers to the idea that central banks proactively cut interest rates in anticipation of possible economic weakness. In other words, given the elevated level of uncertainty central banks would obtain insurance against an adverse outcome by cutting interest rates below the level warranted by their baseline forecasts.

The flipside of this manoeuvre is that, if the risks are neutralised, it may not be that easy for policymakers to reverse the cut. The greater level of scrutiny by politicians and the risk of losing market credibility may pressure central banks to maintain policy rates at low levels while the economy remains strong and the risks have abated.

Other central banks are also facing this delicate decision, including the European Central Bank. Through their multifaceted accommodative policy, central banks have managed to defend against the risks of spikes in market volatility in a period where the economy is weak. However, this was done by motivating high risk-taking at the cost of risking financial stability in the longer term.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.