Fed cuts, but doesn't deliver the guidance the market was looking for

US Fed cuts interest rates for the first time since GFC

The US Federal Reserve cut interest rates overnight by 25 basis-points, taking the US Federal Funds rate to 2.25%. The central bank also telegraphed an immediate end to its so-called “quantitative tightening” program. The cut was widely telegraphed and baked into the market prior to the meeting. As such, markets were focus on two core questions overnight. The first question: why exactly has the Fed performed this about-face on monetary policy, and cut interest rates so soon after the end of its last hiking cycle? And the second, more significant, question: what does this mean about the outlook for the US economy, and its interest rate settings moving into the future?

The Fed’s reasoning and outlook

In his customary press conference after releasing the Fed’s decision, US Fed Chair Jerome Powell outlined three reasons for the rate cut. They are: to insure against downside risks from slower global growth and international trade-policy, to support the US economy through these risks, and to better aid the Fed in meeting its “symmetric” 2% inflation target. The US economy is strong right now the Chair Powell implored, but business investment and other forward-looking indicators are weakening, meaning a “mid-cycle adjustment” to interest rates is required to sustain its expansion. However, this does not necessarily imply, stated Powell, the beginning of a prolonged easing cycle: this cut is a “risk management” cut.

Fed pushes risk-assets down, US Dollar rallies

For financial markets, especially stocks and bonds, recent bullish activity has been underpinned by the notion that the Fed would be beginning an easing cycle from this meeting onwards. Last night’s Fed decision’s commentary has meant that this is less than assured. So: stocks have sold-off, with the S&P 500 falling over one per cent into the market’s close; while short-term bond yields have climbed, as bets of a future rate cuts are marginally unwound in rates markets. Gold is over 1 per cent lower, and oil is marginally down. And the USD has spiked to fresh multi-year highs, pushing the AUD, for one, towards new lows towards the 68-cent level.

Market gut reaction: Fed will hasten slow-down

Most concerningly though, yields in longer-term US (and global) bonds have actually fallen post the Fed announcement. The 2-Year/10-Year interest rate differential on US government bonds has narrowed to 13 basis points – a significant 7-point plunge, as it currently stands. Traders are betting on slightly higher interest rates than previously though in the short-term; but a more imminent end to the US business cycle in the longer-term. Effectively, this means, having digested the Fed, the market is betting on a Fed-policy misstep, and a more rapid arrival of a US economic slowdown, as-a-result. This dynamic is fundamentally bad for risk assets – and the global economy, at large.

Australian news: US CPI beats

Australian CPI data was released yesterday morning, and beat economist expectations. Headline inflation came-in at 1.6% year-on-year for the June quarter, exceeding the forecast figure of 1.5%, and printing higher than the March quarter’s shock 1.3% figure. Though perhaps good news all-in-all for the Australian economy, perusing the fine print in the ABS’s figures delivers a slightly more modest outlook for price pressures in the Australian economy. As the RBA had somewhat flagged earlier on in the year, higher fuel prices underpinned the lift in consumer prices last quarter, driven, of course, by what’s proven to be a transitory climb in global in oil prices in the first part of 2019.

Traders slightly unwind bets of RBA cuts

Nevertheless, despite the fact domestic drivers of inflation are still lacking within the Australian economy, and the inflation rate remains well below the RBA’s 2-3% target band, the better than expected CPI print lead to a small repricing in interest rate markets. Fundamentally, another interest rate cut from the RBA is expected before the end of the year – most likely in October. But the probabilities of such an event, according to the interest rate futures curve, did marginally diminish courtesy of the CPI-data-beat. The Australian Dollar lifted slightly yesterday as a result – though that price-driver proved a temporary phenomenon overnight as markets prioritized the outcome of the US Fed meeting.

Bank of England to take the torch tonight

Markets will prepare for another loaded night of economic data, tonight. The highlight will be the meeting of another central bank: the Bank of England, who are more-or-less certain to keep interest rates on hold. Given the policy outcome is considered all-but-assured, market participants’ interest will be directed towards what the BOE says about the strength of the UK economy going moving into the back-end of 2019. Financial markets have recently moved to price-in a very strong chance that the BOE will cut rates before year end, as it becomes clearer that UK Prime Minister Boris Johnson is driving the country towards a no-deal Brexit -- and a subsequently, a likely significant economic shock.