Fed 50bps cut—more to come

Sam Vereecke, CIO fixed income, takes a look at the latest Fed cut and its wider implications.

Fed cut

Inflation is normalising, and the labour market is cooling from its previously overheated state. The economy is on a trajectory that typically leads to further weakening. The fiscal impulse that keeps the consumer strong is fading. The economy is a complex dynamic system, and once it gets in motion, it requires an opposing force to slow it down or reverse it. We don’t see that force for now. The Fed is trying to achieve that effect by cutting. Jerome Powell managed to convince the FOMC yesterday to reduce the policy rate by 50bps. He wants to preserve the current ‘still solid’ picture by bringing the policy rate to a ‘more neutral’ stance. His focus is on preserving a healthy labour market, not on inflation. Either way, he would never say he is worried.

But the path to neutral is more cuts. A rates trajectory that normalises policy to neutral rates (maximum 3%) is the minimum required. Many of these cuts are already priced in the short end of the U.S. yield curve. A more important economic slowdown would require additional easing, which is not yet priced in.

The next meeting is just after the U.S. elections and is unlikely to try to catch political headlines; hence, a single cut of 25bps is reasonable. This opens the door to another series of cuts into the December meeting and in the new year. On a confirmation of further deterioration, another jumbo cut is likely.

Curve

If we look further up the curve, the 2- and 10-year yields are only a couple of basis points apart at around 3.7%, so that part of the yield curve is essentially flat. The forward rates market is pricing a steeper curve already: 2-10y to go from flat to 0.40% over the next six months. This may make sense, but we expect it to materialise faster. This warrants our current overweight duration stance, with a more important overweight on the shorter end of the curve (a curve steepener): it has worked well over the past couple of months and there is more to go.

Inflation

As discussed in a previous blog post, we had been expecting inflation expectations to come down in the context of a weakening macroeconomic outlook, combined with lower inflation prints. This has been the case: short-term inflation expectations have come down significantly. Two-year U.S. inflation expectations in the bond market have dropped below 1.7% from above 2.9% in Q1. They are starting to look like attractive entry points for inflation-linked bonds. We would start to add on dips. The more negative you are on the macro-outlook, the more you want to delay your entry points, as in that case further weakness is to be expected. But Fed cuts are likely to stoke fears about rising inflation. This, together with some positive basis effect in some inflation components, may make the rates market more bumpy than desirable. But we’re used to it by now.