Federal Reserve cuts rates in pursuit of its dual mandate

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What happened?

The Federal Reserve has cut interest rates for the first time in a decade as part of a broader global effort by central banks to insure against economic risks and revive flagging inflation expectations. The Federal Open Market Committee voted for a quarter-point reduction with two dissenting votes to leave policy unchanged. The lowering of the federal funds target range to 2–2.25% is the first reduction since December 2008, when rates were cut close to zero during the global financial crisis. The Fed also announced that it would halt operations to unwind its balance sheet—two months earlier than had been initially targeted.

In his press conference, Fed Chair Jerome Powell noted that the Fed has moved to a more accommodative policy over the course of the year, which has shored up confidence and helped the economy to perform in line with expectations. Today's cut was designed to keep the outlook favorable amid risks from trade tensions and weaker global growth, while also helping to address inflation, which so far this year has fallen further below the Fed's 2% target.

Investors had been prepared for a rate cut. Just ahead of the FOMC decision, markets were priced for a 25-basis-point (bps) cut with a 17% chance of a 50bps cut. In the minutes after the announcement, markets were little changed, but Powell's comments at his post-meeting press conference triggered bigger moves. The S&P 500 fell by nearly 2% at one point before losses narrowed to 0.7% nearing the close. Two-year US Treasury yields rose by 3bps over yesterday's close. The dollar gained 0.6% against the euro.

What comes next?

Financial markets continue to expect that further easing will be necessary to protect growth, and after today's move are still pricing in two or three additional 25bps rate cuts by the end of 2020. We believe this is excessive, given the relative resilience of the US economy to-date and recent evidence that suggests inflation may be bottoming out. The shift comes at a time when US unemployment is close to its lowest level since the 1960s, and credit conditions are already accommodative, based on the National Financial Conditions Index from the Chicago Fed. Barring a marked deterioration in the economic outlook, we expect the Fed to implement at most one more 25bps cut and then to remain on hold through the end of 2020.

Over the coming months, the progress of trade talks between the US and China will influence the outlook for the economy and the Fed. While we do not expect a breakthrough leading to a reduction in tariffs, we believe talks are likely to continue with no major escalation in tensions. This should, in our base case, permit a gradual recovery in business confidence, and a reduction in market expectations for Fed rate cuts.

We will also be monitoring the reaction of other central banks around the world. The recent undershooting of inflation targets globally has raised concerns that the world's major economies are at risk of following Japan into a prolonged period of low growth and near zero inflation. Fed easing increases the scope for other policymakers to ease, reducing the risk of damaging currency appreciation. Earlier this month, European Central Bank President Mario Draghi indicated that policymakers were "determined to act" to reverse a decline in inflation expectations, and intimated that the central bank's inflation goal of "below but close to 2%" could be dropped for a more explicitly symmetrical 2% target. We expect the ECB to cut its deposit rate, which is already at –0.4%, by 10bps at both its September and October meetings this year. The Swiss National Bank, which has a policy rate at – 0.75%, will also come under pressure to ease further to limit the appreciation of the franc.

Over the medium term, we will be watching how the Fed evolves its thinking around its statutory goals of "maximum employment, stable prices, and moderate long-term interest rates." Inflation has consistently fallen short of the Fed's 2% target despite interest rates being lower than in the past, and market pricing indicates skepticism that the Fed will hit the target in the future. The Fed may embrace a new interpretation of maximum employment, or somehow suggest that inflation will be encouraged to rise above 2% to make up for the shortfall in previous years. It may also introduce new monetary policy tools to help reach its goals and to provide more support during economic downturns.

Powell recently underlined the importance of sustaining growth, pointing out that improvement in the jobs market has "started to reach communities at the edge of the workforce," and he made similar comments in today's press conference. While the current expansion is now the longest of the postwar era, it also has the distinction of being the weakest, with GDP growth averaging only about half its normal rate. Against this backdrop, gains have accrued unevenly across the economy with lower-skilled workers only recently reaping the benefits from increased employment opportunities and rising wages. In an effort to both preserve and extend these recent gains, the Fed may well be willing to adopt an easier policy stance than static measures such as the unemployment and inflation rates alone might suggest.

What does this mean for investors?

We think this low rate environment should be positive for equities and should also support "carry trades," which help to boost portfolio income.

1. In our FX strategy, we overweight a basket of higher-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). We think these currencies should benefit from a favorable carry environment, as well as steady global and emerging market economic activity.
2. Markets are underpricing inflation, in our view, especially with the Fed committed to achieving that part of its dual mandate, so we recommend an overweight to Treasury Inflation-Protected Securities (TIPS) versus US government bonds.
3. We see good long-term value in emerging market sovereign bonds. US dollar-denominated emerging market sovereign bonds have a favorable longer-term risk-return outlook, in our view, with spreads of around 330bps over US Treasuries. This is particularly attractive at a time of low rates.
4. We continue to recommend an overweight to US, Japanese, and emerging market stocks which should continue to fare well in an environment where central banks are committed to supporting growth. To manage the risk of equity drawdowns if growth disappoints or if trade negotiations fail to reach a timely resolution, we continue to recommend an overweight to long-duration Treasuries and an underweight to international developed market stocks (especially Eurozone stocks). We also recommend a variety of investment themes with the potential to offer attractive yield. For example, short-term corporate bonds offer attractive current yield without taking on excessive credit or interest-rate risk, and master limited partnership (MLP) bonds offer attractive coupon income relative to other investment grade sectors.

While we expect rates to remain lower for longer, we believe that US fixed income markets may be overstating the risk of sharp rate cuts in the near term. We therefore prefer stocks and cash over shorter-maturity US government bonds.

We expect the Fed to lower rates by more than the ECB and this narrowing interest rate differential to weaken the US dollar versus the euro. Easier monetary conditions worldwide should also help stabilize the flagging Eurozone industrial base, especially in Germany, where the manufacturing purchasing managers' index reading fell to 43.1 for July, below the 50 level that separates expansion from contraction. This would also benefit the euro, and we forecast EURUSD at 1.15 and 1.17 in six and 12 months, respectively. More broadly, we expect easier monetary conditions to support risk-on sentiment among investors, which is positive for emerging markets relative to the US dollar.

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