Where from now, as the FED cuts rates?

The wait for the long-awaited monetary policy announcement from the US Federal Reserve (FED) is over. On Wednesday short-term rates were revised lower by 25 basis points. This was the first rate cut in a decade, and the first following a three-year monetary tightening program which the FED embarked upon. The FED’s last rate hike took place in October 2018. However, towards the end of last year, comments from FED committee members indicated that pressures on economic figures were pointing to the downside. The trade war, between the world’s two largest economies, was being touted as one of the main culprits for a slowing US economy.

Since those very first comments by FED officials back in December, financial markets had anticipated a stop to the monetary tightening program (higher interest rates) and a reversal in monetary policy. In other words, financial markets anticipated that the US central bank will stop raising interest rates and instead opt for a looser monetary policy. The latter is an environment which usually supports asset prices.

While no rate cuts were announced in the first six months of the year, markets have widely anticipated this week’s rate cut. Many were expecting a more aggressive FED or a 50 basis points interest rate cut, against the 25 basis points cut announced on Wednesday. The announcement was made mid-week around 8pm local time. European markets were closed at the time while US markets were two hours away from closing. Before the announcement the S&P 500 was trading relatively flat. As news hit the wire, US equities nose-dived, as many were expecting a less optimistic speech from FED chairman Jerome Powell.

Since the beginning of the year, till close of trading on July 30 in Dollar terms, US equities have gained a whopping 20 per cent. During the same period 7 to 10-year US Sovereign bonds gained almost 7 per cent, while US Investment Grade bonds increased by over 12 per cent. US High Yield bonds followed with a nearly 11 per cent gain.

During this week’s final trading sessions, some of the gains witnessed so far this year, were reversed, as FED chairman Jerome Powell indicated, that going forward, the US central bank is expected to be less aggressive in cutting short-term rates. Investors globally were generally expecting more dovish (less optimistic) comments from the FED. That is, central bankers give market guidance of what to expect in terms of monetary policy changes. This week the FED did not give markets what they were expecting. Instead investors got a more hawkish message. To be fair, US economic data has improved lately and hence why the not so pessimistic comments.

Mr Powell’s speech confirmed that the FED’s first rate cut does not mean an aggressive rate-cutting regime going forward. On the news the US Dollar gained while President Donald Trump tweeted his disagreement on the decision once again. While President Trump agreed to the rate cut, he did not like the FED’s comments which followed after the decision.

The US President, who is an avid believer of monetary easing, has constantly criticized the US central bank, following the tightening program which started back in 2016. His main argument is that inflation is still low and short-term rates should be much lower. The FED thinks otherwise. In addition, the FED is an independent institution and definitely does not want to give markets the impression that it is bowing down to political pressure.

In less than a year, yields on 10-years Treasuries declined from a seven-year high of 3.15% reached in October last year, to 1.95%, two months ago. The significant drop in the 10-yield and the corresponding increase in bond prices, came on the back of expectations of a more accommodative central bank. On Wednesday, the yield on the 10-year Treasury broke beyond the 2% level (prices declined).

Following the news, on Thursday European equities opened positive. On the one hand we have the European Central bank which is expected to be more accommodative and not expected to follow on the footsteps of the FED. Secondly, a stronger US Dollar, makes goods and services produced in Europe more appealing to consumers on the other side of the Atlantic.

Moreover, a strong US Dollar is negative for commodities, since the latter are mostly traded in US Dollar and hence a stronger US Dollar makes these commodities more expensive. Both gold and oil declined. Similarly the MSCI Emerging Market Index lost nearly 1% to trade at the lowest level in six weeks.

Whether this week’s interest rate cut will be a one-off cut is yet to be seen. However, what is for sure is that markets have grown highly dependent on central bankers’ forward guidance. Will this week’s FED decision dampen investors’ reliance on forward guidance?

 

Gabriel Mansueto is Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]

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