Don’t Be So Sure the Fed Is Cutting Rates

(Bloomberg Businessweek) -- Chief economists at two Wall Street houses are questioning the conventional wisdom that the Federal Reserve is about to start cutting short-term interest rates to sustain the economic expansion. They make a good case that traders may have gotten ahead of themselves.

Deutsche Bank Chief Economist Torsten Slok and his team created this chart, which is appropriately headlined, “The market is almost always wrong about what the Fed will do.” The red line represents the path of the federal funds rate—i.e., the interest rate on overnight loans of bank reserves that the Fed controls. The dotted lines represent what traders in the futures market thought was going to happen to the funds rate. From 2001 to 2004, traders expected the funds rate to rise, but it fell. From 2004 to 2007, they expected it to flatten out, but it rose. From 2009 to 2016, they expected it to rise, but it stayed flat. Et cetera: Wrong every time.

The blue line reflects the latest betting by the futures market. Going by the pricing of futures contracts, the market expectation is for the top end of the funds rate range to fall from its current 2.5% to 1.5% by 2021. (As of June 10, the market was reflecting a 98.1% chance of some kind of cut by the end of 2019.) Slok’s snide comment in the chart, also in blue: “Why would the market be right today?”

Jan Hatzius, chief economist at Goldman, Sachs & Co. LLC, is out June 10 with a piece entitled “No Time to Panic.” True, says Hatzius, the May jobs report was a disappointment, with just 75,000 jobs created and a sizable reduction in estimates of job growth in previous months. True, too, there has been “slower output growth and a significant increase in tariff-related uncertainty following the collapse of US-China trade talks last month.”

On the positive side, Hatzius points out that the May jobs numbers were suppressed by Midwest flooding. The three-month and six-month trends in job growth are stronger. The unemployment rate—3.6%—remained extremely low, and business and consumer surveys are positive. The U.S.-Mexico trade deal removes one key source of uncertainty.

Meanwhile, Hatzius observes, inflation is showing some strength, which could make the Fed think twice before cutting rates. In April, inflation equaled its highest level since early 2012-—2.03%—as measured by the “trimmed mean” one-year change in the personal consumption expenditures price index, calculated by the Federal Reserve Bank of Dallas. The April figure, tying the level of July 2018, strips out the components with the most extreme price changes to get an estimate of inflation’s central tendency.

Traders got excited when Fed Chairman Jerome Powell promised on June 4 that the central bank would “act as appropriate to sustain the expansion.” But others, including Bloomberg Opinion’s Brian Chappatta, have pointed out that Powell never once used the phrase “rate cut.” Goldman’s Hatzius argues that Powell wasn’t being especially dovish when he took note of short-term turbulence. “A speech from the Chair focused exclusively on longer-term issues at a time of sharply increased worries about trade policy might otherwise have come across as ‘out of touch’ to some market participants,” he writes.

There’s a school of thought that the bond market can force the Fed’s hand, the idea being that if the Fed did not ratify market expectations by cutting rates now, its behavior would be perceived as a reversal and a tightening of financial conditions. Hatzius doesn’t buy that, either. “For one thing, we expect Fed officials to be very careful not to deliver an unconditional hawkish message, but to continue emphasizing that they will respond to shocks as needed to attain their mandate.”

We’ll get a clearer reading when the rate-setting Federal Open Market Committee meets in Washington June 18-19. That’s right before President Donald Trump is hoping to meet with his Chinese counterpart, President Xi Jinping, on the sidelines of the G-20 summit. “In such an environment,” Hatzius writes, “the right course of action is to retain optionality.” Hatzius expects that the FOMC outlook after the meeting will be somewhat downgraded, and a few participants will signal their expectation of rate cuts, but the median rate forecast for 2019 by participants in the FOMC deliberations will remain unchanged—and there will be “no signal from Powell that a cut is in fact imminent.”

If Hatzius is right, a lot of futures traders who swallowed the rate-cut story whole will be fighting to get out of losing positions in a week or so.