Markets are largely undaunted about expecting further Fed rate cuts — The stock market fell fairly sharply after Fed Chair Powell said that Wednesday’s -25 bp rate cut was not the beginning of a long string of rate cuts but was simply a «mid-cycle adjustment.» In addition, two FOMC members dissented from the decision and voted to leave rates unchanged. Mr. Powell said, «It’s not the beginning of a long series of rate cuts,» but added, «I didn’t say it’s just one» cut.
Mr. Powell’s comments indicate that the FOMC at this point is only interested in only one or perhaps two rate cuts, but certainly not the four cuts that the market has been forecasting through the end of 2020.
Still, the markets were largely undaunted by Mr. Powell’s relatively hawkish view. The federal funds futures curve on Wednesday turned less dovish by only 5-7 bp. The federal funds futures market is still anticipating a total of 3.7 rate cuts through the end of 2020 (including yesterday’s cut) versus 4.0 cuts prior to yesterday’s FOMC meeting.
The market is now discounting the relatively high chance for another rate cut at 63% at the next meeting on September 18 and 80% for the following meeting on October 30.
The markets are signaling a belief that the Fed is being too optimistic about the economic outlook and that the Fed will eventually be forced to ease by more than it currently anticipates. In the Fed’s defense, the current economic outlook depends heavily on trade developments and the Fed is currently taking a cautious, data-dependent view on the need for further rate cuts. For example, if the U.S. and China were to suddenly reach a comprehensive trade agreement and drop all the penalty tariffs, then no further rate cuts might be necessary. By contrast, a new round of US/Chinese trade tariffs would require more interest rate cuts.
In a supportive development for the Treasury market, the FOMC on Wednesday announced that is ending its balance sheet reduction program as of August 1, which is two months earlier than its previous plan for the end of September. That means that the Fed will now start buying Treasury securities in order to offset maturing securities, thus keeping its balance sheet constant and halting the permanent reserve drain. Mr. Powell said that the early end of the program was due to consistency. It wouldn’t make sense to ease monetary policy with interest rate cuts while at the same time tightening monetary by allowing the balance sheet to decline and drain reserves.
The end of the Fed’s balance sheet reduction program means that the balance sheet level will now move sideways near its current level of $3.80 trillion, which is down by $713 billion from its peak in Jan 2015 but up by $2.9 trillion from the pre-crisis level. At some point, the Fed is likely to start pushing its balance sheet slightly higher in order to match the natural increase in the demand for reserves that occurs as the U.S. economy grows.
Senate debt ceiling vote expected today, after delay — The Senate today is expected to vote on the 2-year budget cap and debt ceiling suspension bill that the House passed last Thursday before leaving for its August recess. Senate Republican leaders are reportedly having trouble corralling even half of their members to vote in favor of the bill and they were forced to delay the vote from Wednesday. The bill is expected to pass, however, with enough votes from Senate Democrats. Senator John Thune (R-SD), the No. 2 Senate Republican, said on Wednesday that «failure is not an option» on passing the bill since the alternative is a debt ceiling crisis and Treasury default in September or October.
US/Chinese trade talks show no progress but will at least continue — The US/Chinese trade talks restarted in a rather perfunctory manner on Wednesday with only one negotiating session and an early breakup of that session, suggesting there wasn’t much to talk about. There appeared to be little progress in Wednesday’s talks, which focused mainly on China’s willingness to buy U.S. farm products. The two sides at least agreed to another round of high-level talks in September to be held in Washington. There were reports that mid-level talks will be held through August.
The US/Chinese trade talks obviously have a long way to go since the two sides have not even gotten past the preconditions yet on ag purchases and Huawei. The two sides have yet to restart negotiations on the difficult structural issues that produced the breakdown in the talks in May. The markets took Wednesday’s news on the US/Chinese trade talks in stride with little net reaction, suggesting that the markets were not expecting much out of this week’s meeting and were just happy that the talks will continue at all.
BOE expected to acknowledge increased Brexit risks — The Bank of England at its policy meeting today is expected to leave the base rate unchanged at 0.75% and continue to back off its previous bias toward tightening. Despite the inflationary implications of the recent plunge in sterling to a 2-1/4 year low, the BOE will be on guard for whether it needs to ease in coming months to match the dovish tone in the rest of the developed world and address the increased no-deal Brexit risks on October 31 with Boris Johnson as the new Prime Minister. The market is discounting the odds for a BOE easing after the October 31 Brexit deadline at 41% for November and 50% for December.
U.S. ISM manufacturing index to recover modestly from a 2-3/4 year low — The consensus is for today’s July U.S. ISM manufacturing index to show a small +0.3 increase to 52.0 following June’s -0.4 point decline to a 2-3/4 year low of 51.7. The markets will be watching the July ISM new orders subindex, which fell by -2.7 points in June to 50.0, thus hovering on the edge of a contraction.