Jay Powell extols the virtue of insurance

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When Jay Powell spoke on Wednesday, the Federal Reserve chair did not push back against market expectations of an “insurance” rate cut later this month.

The upshot was that the S&P 500 briefly broke 3,000 for the first time, while the dollar retreated and short-dated Treasury yields dropped.

During his addressed to the House of Representatives financial services committee, Mr Powell noted that at the Federal Open Market Committee meeting on June 18/19:

“Many FOMC participants saw that the case for a somewhat more accommodative monetary policy had strengthened.”

Mr Powell followed that observation with this line that green-lights a late-July easing:

“Since then, based on incoming data and other developments, it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the US economic outlook. Inflation pressures remain muted.”

The Fed chair also touched on how:

“Economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the US economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent than we currently anticipate.”

The inflation comment is significant as Mr Powell had previously described low consumer price pressure as being “transitory”. That situation now appears “more persistent” in nature. No matter last week’s resilient jobs report for June and some detente over trade between the US and China, Mr Powell has charted a course that chimes with the bond market’s long-held view of slowing growth and modest inflation pressure. And during the Q&A session with House FSC members, Mr Powell notably said the jobs report did not alter his concern over trade tension hurting the economy.

The tone of the testimony, according to Ian Lyngen at BMO Capital Markets, was “decidedly dovish”. He says:

“Overall, ‘act as appropriate’ has clearly been defined as act preemptively and sooner rather than later.”

The rationale of an insurance rate cut is laid out by Steve Englander of Standard Chartered:

“Monetary stimulus is much harder if the lower bound is hit. Below-target and falling inflation means that the cost of being mistakenly tight is higher than the cost of easing that turns out not to be needed.”

The US dollar weakened and Treasury yields fell in reaction, led by the policy sensitive two-year note. Mr Powell’s testimony was followed by the FOMC meeting minutes for June, which showed that many members saw a stronger case for easing due to rising macro uncertainty.

That still leaves the two-year yield above its late-June nadir of 1.70 per cent, when expectations for a 50 basis point cut in July were rising.

One could argue that insurance should arrive on the heavy-handed side, which was hinted at by Wednesday’s bond market pushing up the odds of a 50bp cut for July — but it appears for now that a 25bp cut is the base case at the end of the month. All told for this year, the January Fed funds future contract for 2020 implies a rate of around 1.70 per cent, effectively 75bp of easing.

That chimes with the view of economists at Bank of America Merrill Lynch:

“We expect the Fed to cut a cumulative 75bp with the goal of achieving a ‘midcourse correction’. The FOMC is not in agreement and we will likely see a number of hawkish dissents at the upcoming meeting (potentially as many as three). But, nonetheless, Fed chair Powell sent a strong signal — he is prepared to cut.”

Once rate cuts arrive the next question, and one that will not be answered for some time, is whether additional central bank easing succeeds and extends the economic cycle. By then, the scale of damage inflicted by trade tension should be clearer and perhaps more importantly investors will know whether a corporate earnings recession is unfolding.

Another reason for caution about the US economy was flagged earlier this week by the New York Fed, with its recession indicator having climbed to 32.9 per cent, up from 29.6 per cent the previous month. This represents its highest reading since 2009 and is based on the yield curve relationship between three-month and 10-year Treasury yields.

Given the extended inversion between these two benchmarks, a higher risk of recession is hardly surprising — but what has people talking is that once the Fed indicator gets above 30 per cent, a downturn has arrived since the 1960s. A break above the 30 per cent level occurred in June 1990, July 2001 and August 2007, ahead of recessions and tough times for equities and credit.

Whether the current signal is vindicated is very much up for debate.

A FOMC easing this month and beyond would for starters pull the yield for the three-month bill down from 2.25 per cent and erase the yield curve inversion, hence the talk of an insurance rate cut that nurtures the current expansion.

But another factor to consider is what has pulled the 10-year Treasury yield down from this year’s peak of 2.79 per cent (and in turn helped drive the NY Fed’s recession indicator above a 30 per cent reading). This pronounced drop in 10-year yields cannot be viewed in isolation, argues Nicholas Colas at DataTrek, who says:

“Treasuries do not trade in a vacuum, and one must decide if a European recession (forecast by negative sovereign rates across the region) will spill over to the US.”

Nick also highlights how rising oil prices also played a big role in 1990, 2001 and 2007 when the NY Fed recession indicator rose above 30 per cent. He notes:

“The US has not seen a recession since 1970 without oil prices doubling.”

Quick Hits — What’s on the markets radar

House backs Jay Powell — Maxine Waters, the FSC chair, set the tone in her opening remarks with a strong endorsement of Mr Powell and his stewardship of monetary policy. She urged the Fed chair and his colleagues “not to submit to the high pressure tactics of this president”. During Q&A with Ms Waters, this exchange stood out:

Bank of Canada stuck on hold — The BoC held overnight rates steady at 1.75 per cent as expected. It marks the sixth straight meeting where the central bank has remained on hold and a muted reaction from the Canadian dollar suggests this was well priced into the market.

Sale of 10-year Treasuries — Demand was a little weaker than seen for recent auctions. This reflects a big steepening in the yield curve on Wednesday as two-year yields dropped sharply on Mr Powell’s dovish statement. The curve between two- and 10-year yields has popped above 0.20 percentage points, but still some way off from the 0.30 percentage point area reached last month. A steeper curve and rising inflation expectations are the usual market outcomes when an easing cycle beckons and both played out on Wednesday. The 10-year US break-even rate has popped to 1.75 per cent, up from last month’s low of 1.62 per cent.

Calling time on the HKD carry trade — A modest pullback in the Hong Kong dollar from its recent two-year high may not signal a restoration of carry trades (buying the higher-yielding US dollar versus selling the HKD). The squeeze on HKD carry trades has been triggered by a lower US Libor, while upcoming corporate dividend payments and expected initial public offerings pushed local interbank rates (Hibor) to their highest level in a decade.

TD Securities make the point that US dollar Libor should fall as the Fed cuts interest rates, “thus limiting any re-widening of the Libor-Hibor spread”.

TD conclude:

“The net result is that the USD-HKD carry trade will continue to remain an unattractive proposition, especially given that HKD volatility has also increased.”

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