To characterise the Federal Reserve’s Open Market Committee meeting late last month, we would say the doves are now less dovish.
Just one more cut has been priced for this year and, tellingly, only one voter opted for a larger 0.5 per cent cut this time, with two voting in favour of no cut.
The balance is clearly more hawkish, owing to the fact that financial conditions are still supportive of the economic outlook and despite the rate cut, there appears nothing of any urgency happening in the economy or the rates markets.
The yield curve was slightly flatter on the news, with Fed chairman Jerome Powell making it clear this cut was necessary in light of slightly softer economic data and to mitigate a possible economic downturn: “In terms of firepower, I think the general principal is it can be a mistake to hold on to your firepower until a downturn gains momentum.”
Significantly, he also made it clear he was not in favour of continual cuts and entering into the negative rates environment.
In fact, quantitative easing would likely be the solution before this situation was called for.
As Mr Powell alluded to in his speech, monetary policy cannot do all the heavy lifting.
- The Fed committee is slightly less dovish
- Demand for debt is still there
- Pressure might be applied to the Fed chairman for monetary stimulus
“Over the long run, we can’t really affect the growth rate of the US; the potential growth rate of the US is not a function of monetary policy. It is a function of other things.”
From extensive studies we know QE is becoming less and less effective in accelerating aggregate demand – an important driver of growth – so could fiscal stimulus be the answer?
The implications for bond markets, from a relative perspective, is that despite easing and unappealing real yields, demand for debt has not gone away.
Forced into a corner, many money market managers and institutional investors have a forced hand at what they can buy.
This is driving yields across the risk spectrum down.
Credit rarely moves sideways and while central banks ease, companies battle with the onset of greater tariffs and more complex supply chains, with this margin squeeze bound to be passed onto the consumer at some stage.
Credit may therefore become more stressed and we may see default rates pick up; high-yield and lower-rated investment grade bonds could be first in line for significant widening.
The overnight rate (repo rate) spike earlier in September of levels close to 10 per cent sparked some concerns around a US dollar shortage.
The demand from smaller banks, and in turn the larger banks’ demand for borrowing from the Fed, forced the overnight rate into double digits.
We have yet to find a watertight and highly plausible reason for this aside of the supply-demand dynamic, but needless to say, it is of some concern for liquidity levels in the market and something we will continue to monitor.