Market views: How will the Fed’s rate cut affect assets?
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The US Federal Reserve cut of the federal funds rate by 25 basis points on Wednesday (July 31) marks the first such reduction since the global financial crisis in 2008.
Chairman Jerome Powell said the move, which reduced the target range to 2%-2.25%, was to "insure against downside risks" rather than signal the start of a monetary easing cycle. The central bank also hopes the cut will raise inflation to its 2% target.
The Fed also accelerated its plan to stop shrinking its $3.6 trillion in bond holdings by two months. It had recently let some of its bond holdings mature without replacing them, pivoting from the monetary stimulus through bond buying during the financial crisis in 2008.
While markets generally anticipated Fed would cut rates some traders had anticipated it to drop the federal funds rate by 50bp to preempt an economic slodown, courtesy of the ongoing trade war. There are signs that earnings are faltering in both the US and China because of this stand off.
The second-quarter earnings of the companies in the S&P 500 fell 2.6%, according to estimates by FactSet, a US-based financial information provider. Meanwhile in China, 40% of the 1,600-plus firms that have offered guidance for their first-half results predicted earnings would drop from the same period of 2018, according to data compiled by Bloomberg.
Given this combination slowing profits and an ongoing stand-off, AsianInvestor asked nine experts whether the Fed had done the right thing, and the likely impact of the cut on US and global assets.
The following extracts have been edited for brevity and clarity.
Antoine Lesné, head of EMEA strategy and research, SPDR ETFs
State Street Global Advisors
Clearly the Fed is concerned about the impact of trade wars and the loss of momentum globally, but the accompanying statement may not have sounded as dovish as what the market would have liked.
After some disappointment from the European Central Bank last week, it’s now the Fed’s turn. We expect the US dollar to stay well behaved and for bond yields to increase potentially in the front to intermediate end of the curve.
How will equity markets react to the news? It may not be too pleasant, especially as earnings surprises are relatively low and more accommodation may be needed to push asset prices higher.
As an alternative, bills could be a place to be in as they still exhibit a decent yield and the FOMC (Federal Open Market Committee - the Fed's monetary policymaking board) seems in less of a hurry to cut it down.
Andrey Kuznetsov, senior credit portfolio manager
Hermes Investment Management
The change in interest rate environment we are experiencing has far-reaching implications for fixed income asset allocators.
Floating rate products will continue to struggle as the Libor forward curve remains inverted and duration is no longer on the list of top risks for investors. This is evident from the leveraged loan flows in the US year-to-date.
Until we see a pick-up in the underlying economic backdrop, higher quality credit will continue to outperform lower quality on beta-adjusted basis as investors refrain from funding weak issuers that require higher economic momentum and focus on issuers that have tools such as dividend and buyback cuts to offset macroeconomic weakness. For the same reason in both US and Europe subordinated instruments will continue to perform well.
Security selection will be key going forward for several reasons. First, the importance of roll-down (bond prices rising as their remaining maturity shortens) increases in a lower interest rate environment that is accompanied by steep credit curves.
Secondly, as a substantial part of the high yield market is trading above call on the back of solid year-to-date performance, maximising convexity (larger price increases as yields fall) through security selection in credit portfolios has never been so crucial.
Charlotte Chan, portfolio strategist of intermediary business, North East Asia
Fidelity International
Having hiked nine times in the past four years, the Fed has just reversed course and, as expected, implemented a 25bp rate cut to target a range of 2%-2.25%.
This cut should be seen along the lines of previous ‘mid-cycle’ adjustments, similar to the cuts in 1995-1996, when the Fed implemented three cuts within seven months, and managed to extend the economic upcycle.
While the Fed’s next steps will be data-dependent, it looks likely that, unless economic data improves significantly during the next couple of months, a further cut will be implemented later this year, similar perhaps to what happened in 1995-1996.
Olivier Marciot, investment manager
Unigestion
Most assets have become rich as a result of central bank action. Currently, hedging assets are more expensive than risky assets, which could trigger correlation distortions and limit their defensiveness. This favours relative value plays over long beta exposures.
As central bank support is here to stay for at least until the end of the year, the macro environment remains benign enough to warrant accommodation while market sentiment is mixed and valuation less favourable. Therefore, we currently favour carry strategies (in credit and foreign exchange) and tactically hedging risk asset exposure through convex optional positions on equity indices.
Kristina Hooper, chief global market strategist
Invesco
The key takeaway is that the trade wars can be very dangerous – and the Fed is realising this. I have warned that markets weren’t fully comprehending how negatively impactful they could be. It’s not just the actual tariffs – it’s more about the economic policy uncertainty they create, which tamps down business spending.
Stocks fell when Powell characterised the rate cut as an adjustment, rather than being part of a trend. However, I believe he had a loftier purpose in mind – I think he did that to push back on the White House and signal the Fed’s independence. I believe that in his mind, a short-term sell-off was a small price to pay in order to assert the Fed’s right to self-determination.
While stocks fell today, I think that will reverse in the coming days. Risk assets are likely to benefit from more accommodative monetary policy. And investors are likely to move out on the risk spectrum to reach for yield.
Christophe Donay, chief strategist
Pictet Wealth Management
Core government bonds continue to provide protection to portfolios, but with low interest rates appearing here to stay, declining (and even negative) yields mean their cost to investors is increasing.
Central banks’ capacity to prolong the current expansion is limited, given low nominal and real rates and their already bloated balance sheets. We also believe massive asset purchases could soon show their limits, leaving policy makers to thrash around for a new approach to economic policy. It is unlikely that a status quo on trade tariffs will be enough to revive world growth in the coming months.
Overall, we remain cautious on equities, believing a lot of good news has been already baked into prices. Indeed, market expectations for Fed rate cuts have been excessive and the earnings-bond yield shows that valuations are stretched.
Euro investment grade credit spreads should remain supported by an accommodative European Central Bank (ECB). In an environment of easier monetary policy, this position is a relatively low-risk way to harvest carry. Investment grade spreads could tighten further if a dovish ECB leads investors to reach for yield. Leverage is around the median for the past decade, and interest coverage is healthy. Euro investment grade creditors also have lower debt levels than US dollar issuers.
Mark Haefele, chief investment officer
UBS Global Wealth Management
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 330bp over US Treasuries. This is particularly attractive at a time of low rates.
We also recommend a variety of other investment themes with the potential to offer attractive yield. For example, a dividend-focused strategy could top the MSCI EMU's (European Economic and Monetary Union) expected yield of about 3.7%.
In addition, we think the current market environment represents a sweet spot for US equity buy-write strategies, which involves buying equities while systematically selling call options to earn additional income in exchange for sacrificing some upside exposure.
Michelle Meyer, US economist
Bank of America Merrill Lynch
The New York Fed will start reinvesting agency debt and MBS (mortgage-backed security) maturities & pre-payments in the Treasury market starting in August. The Fed will initially reinvest across the Treasury curve in-line to "roughly match the maturity composition of Treasury securities outstanding". The market will first learn the schedule Treasury purchases on August 13.
Overall, the market welcomed this action not only for the simplicity of the message but also because it will modestly help ameliorate US dollar funding pressures that we expect to see with upcoming elevated Treasury issuance.
We see risks of further short-term US dollar strength ahead driven by the interest rate differential channel, given that current market pricing of Fed cuts is substantially more aggressive than the mid-cycle profile that Powell indicated.
Lewis Alexander, Chief US Economist
Nomura
We expect an additional drag on growth from other aspects of policy to contribute significantly to a second cut later in the year. Even with the agreement to lift spending caps and suspend the debt limit, Congress and President Trump still have to reach an agreement on spending priorities for the next fiscal year. Another US government shutdown in October remains a possibility.
We continue to expect US-China trade talks to break down later this year. The ongoing Brexit uncertainty may also prove to be a modest drag on the US economy. This all suggests there is room for additional easing in October.
The recent deal to suspend the debt limit through July 2021 means that the Treasury will begin to rebuild its cash balance sooner than we had expected. Treasury’s projections show a cash balance of $350 billion by end-September and $410 billion by end-December, up from roughly $160 billion today.
Rebuilding the Treasury’s cash balance will lower reserves held by banks from roughly $1.5 trillion today to $1.3 trillion by end-September, which could exert upward pressure on market-determined short-term interest rates in coming months. This, in turn, may accelerate the Fed’s decisions to establish a short-term repo facility and restart regular asset purchases to expand its balance sheet and stabilise the level of reserves.
The article has been updated to reflect that the Fed's target range is between 2-2.25%, instead of between 2-2.5% as stated earlier.