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The Fed is Cutting Rates Again Wednesday

October 28, 2019

Last Week This Morning

  • 10 Year Treasury ticked up 2bps on the week to close out at 1.80%
    • German bund spiked to -0.37%
    • Japan 10yr up slightly to -0.15%
  • 2 Year Treasury inched up to 1.62%
  • LIBOR at 1.80% and SOFR at 1.86%
  • China and the US are reporting that Phase 1 of their agreement is “basically completed”
  • The NY Fed increased and extended its emergency repo facility to at least $120 billion through November 14th (man, those corporate tax payments from a month ago are really wreaking havoc…)
  • Deficit hit $984B, up 26% from last year
  • Durable goods fell 1.1%, the first decline in three months
  • New home sales fell 0.7%, while existing home sales fell 2.2%
  • UK’s Brexit deadline is Thursday and will likely petition the EU for yet another extension to January 30, 2020 to avoid a No-Deal Brexit cliff dive
  • ECB left rates unchanged as Mario Draghi hands the reigns to Christine Lagarde
  • Rudy Giuliani butt dialed an NBC reporter and it turns out that wasn’t the first time
  • Congrats to the intelligence community and the US military for finally ridding the world of Al-Baghdadi
  • WeWork contemplating a rebranding to WeNeedCash after paying out more than $1B to its founder to go away…I’m patiently awaiting my $1B offer to depart Pensford


FOMC Meeting – Wednesday

The market has odds of a 25bps rate cut on Wednesday at 90%.  While that feels a little high to me, the fact that the Fed has not been sending signals to lower those odds tells me the Fed is probably cutting.  If it does, it will be interesting to see how it addresses the fact that 5 members were still calling for a hike before year end just six weeks ago.

Here’s what I expect:

  1. Fed Funds cut to 1.50% – 1.75%
  2. No more cuts on the horizon as the “mid-cycle adjustment” is complete
  3. Two dissenters (George and Rosengren)

Powell will try to walk a fine line.  He’ll remain hawkish on the economy overall, but highlight downside risks.  It’s a challenging position because he is trying to sound positive on the economy while simultaneously justifying three rate cuts.  I suspect he’ll blame it on the US-China trade dispute, global economic risks, and tame inflation.

While historical precedent suggests LIBOR could push lower in the coming years, it’s hard to argue with a pause here.  Below is the Financial Conditions Index, showing overall conditions are as accommodative as they have been in more than a year.  It’s tough to justify further cuts from here with conditions already very accommodative.

Source: Bloomberg Finance, LP

But let’s be clear – the real reason the Fed is cutting is because the market demanded it.  While Powell envisions this as a nice landing spot, how long before the market demands more?  If GDP and inflation fall, will the market force his hand again?

What about the health of the global economy?  Germany appears to be on the cusp of a recession, Italy is in a recession, Japan is forecasting negative GDP in Q4, and China’s GDP was the lowest in 28 years.

While the economy does feel strong here, can we really detach materially from the rest of the world if there’s a coordinated slowdown?

Two weeks ago, I argued that accommodative monetary policy could cause a short-term jump in rates. But longer term, the trend will be lower if the global economy continues to slow down.  I still think that to be true.


Where Do Rates Go From Here?

As LIBOR and fixed rates converge, the question borrowers should be asking themselves is, “what do I think will happen 12+ months from now?”

If you believe the global economy is slowing and central bank intervention won’t be able to fend off a recession, retain exposure to floating rates.  Just keep in mind that lending appetite may change in a downturn.  Lower rates won’t necessarily be a great thing if spreads widen or lenders pull back.

If, however, business feels strong and the recent drop in rates feels overdone, I can’t argue with fixing for the long-term, especially with rates below 2.00%.  You might also fall into this camp simply because you’re willing to trade out the potential opportunity cost of LIBOR moving to 1.00% when the trade-off is rates moving back towards 3.0% over the next five years.  “Maybe I miss out on lower floating rates, but if I can lock in for 5-10 years at 1.70%, I can live with that risk.”

Below is a graph of how rates behaved during the mid to late 1990’s.  The Fed hiked 2.50% (just like it has recently), realized it had overdone it, and then cut 0.75% (just like it will if it cuts this week).

  • The 10 Year Treasury jumped 1.50% and didn’t return to the lows for two years.  That would be Q4 2021 in today’s terms.
  • Additionally, a year after cutting, the Fed started hiking again.  LIBOR climbed 0.65% – today that would be about 2.25%.

The recession didn’t come until five years later – 2024 in today’s terms.

Source: Bloomberg Finance, LP

The decision to fix today is probably some combination of:

  1. Long-term rate certainty
  2. Belief that China and the US will reach an agreement on the trade dispute
  3. Removal of refi risk
  4. Opportunity to fix below current floating
  5. Opportunity to fix below where LIBOR might be in a year
  6. A floor limits benefit of lower rates
  7. Bullish outlook on US economy
  8. Inflation is and will continue to increase

If you’re a buyer of sovereign debt and want a 2-handle, you have exactly one option: the US 30-Year Treasury.  It comes with a whopping 2.28% yield right now.

Either you believe that global yields will drag us lower from here…


Markets have overreacted and rates are due for a rebound.


Recession Indicators

So what are the recession indictors suggesting?


New York Fed

Odds of a recession within the next year are at 38%.  This indicator is driven strictly by market data, so a flat or inverted curve carries significant weight.

It’s at levels similar to pre-financial crisis readings.


Federal Reserve Smoothed Recession Probability

Odds of a recession within the next year are less than 1%.  This one does a really good job of predicting a recession once levels hit 20%.


Sahm Real Time Recession Indicator

This is the newest indicator and we covered in extensive detail last month and puts odds of a recession at 0%.  It is driven by changes in the unemployment rate, so if we see that tick up in 2020 this will increase, too.



This index is driven primarily by GDP and has odds of a recession within the next year at 25%.  Note how in 1995 it never spiked the way it did during actual recessions.  It also never got as high as today’s levels.

Source: Bloomberg Finance, LP


This Week

This week not only has the FOMC meeting, but a ton of significant economic data.

– GDP is forecasted to come in at 1.6% vs last quarter’s 2.0%.

– Core PCE (Fed’s preferred measure of inflation) is forecasted to come in at 2.2%, the highest reading in almost two years.

– Jobs report forecasted for a gain of 90k jobs, down from last month’s gain of 136k and the unemployment rate to tick up slightly to 3.6%


Click to Open: The Pensford Letter PDF