Natixis Investment Managers market flash – Federal Reserve

Esty Dwek Roditi

Esty Dwek

What happened?

The Federal Reserve, as expected, cut its benchmark interest rate by 25 basis points for the second time this year, lowering the federal funds rate to a range of 1.75% – 2% as a response to the ‘implications of global developments for the economic outlook as well as muted inflation pressures’.

Mr. Powell stated that the committee will continue monitoring both macroeconomic data and potential risks and that they will act as appropriate to sustain the expansion. However, the tone was interpreted as hawkish as he mentioned only “moderate” support should be enough to support still-solid US growth. Moreover, the latest ‘dot plot’ showed no more cuts for 2019. Indeed, markets were disappointed by the lack of future measures, and President Trump criticized the Fed’s announcement within minutes.

There were three dissents on the Committee, two favouring no cuts, and one favouring 50 basis points. In addition, the new ‘dot plot’ showed increasing uncertainty in FOMC’s next moves, with wide dispersions among expectations.

The Fed will continue to roll over all principal payments from its holdings of Treasuries and reinvest all principal payments from the Fed’s holdings on agency debt and agency MBS, as announced over the summer.

Following some pressure on the repo market, the Committee also lowered the interest rate paid on required and excess reserve balances to 1.8%, setting the rate 20 basis points below the top of the new target range for the fed funds rate.

Since the announcement was in line with expectations, but offered less easing for the future, equity markets were muted, the US dollar strengthened (but has retreated since) and 10-year- US treasury yields drifted higher to 1.8%.

What’s next?

The announcement was in line with our expectations, and we believe a third cut before year end is still likely, even if core CPI and average hourly earnings have picked up. Indeed, overseas softness and ongoing uncertainty surrounding trade are likely to keep some pressure on the Fed, as seen with weaker manufacturing and investment data. Additional headwinds from rising geopolitical tensions in the Middle East, weakness in Europe and a stronger dollar persist.

Markets may need to adjust some of their expectations to a less aggressive easing scenario, and yields can continue to drift higher, but given ongoing easing elsewhere around the world, we do not expect a sharp back up in yields.

We believe that the Fed will continue to watch trade developments, core inflation gauges as well as external growth factors in the coming months.

Investment implications

Yields are likely to remain in a broad range, though they may continue to drift somewhat higher as markets re-price rate cut expectations. However, growth concerns, trade uncertainty, central bank easing and low inflation pressures suggest a sharp correction is unlikely.

We maintain some exposure to core debt for protection, but continue to favour credit allocations.

Risk assets should remain supported by accommodative policies, and should continue to grind higher in the coming months, though valuations and low earnings growth are likely to cap returns. Nonetheless, we still believe that while it may be too late to add much risk to portfolios, it is too early to take it all off.

By Esty Dwek, Head of Global Market Strategy, Dynamic Solutions

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