Friday, July 19, 2019

Market is expecting too much from the Fed

Jun 19. 2019
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ALMOST everyone is convinced that the US Fed is going to cut interest rates at some point this year. So the question is not whether – or not – the Fed will cut but by how much.

The Fed funds futures market is expecting a full percentage point cut spread out over two cuts in 2019, and two more cuts in 2020. The aggressive rate cut expectation is based on the idea that the Fed will pre-emptively ease policy to provide an “insurance” against a slowing economy amid a period of rising uncertainty – such as the renewed trade war with China.

The 1995-1996 mid-cycle rate cut is frequently cited as a historical precedent for the insurance rate cut. During the period, the Fed cut interest rates three times from 6 per cent to 5.25 per cent, and successfully brought the GDP annual growth rate back up to above 4 per cent from around 2 per cent in 1995. 

At this point in time, however, the Fed has much more limited scope to cut rates. For one thing, the interest rate was much higher in 1995. At the onset of 1995, the Fed raised the interest rate to 6 per cent while US core inflation was just 3 per cent, leaving the real interest rate – the gap between interest rate and inflation – at 3 per cent, which was unusually high. 

Now, the Fed funds rate is 2.4 per cent while core inflation is around 2 per cent. Cutting the interest rate more than twice would bring the real fed funds rate back into negative territory, something the Fed will likely avoid absent the threat of recession. 

To make matters worse, the stock market has recently been pricing in the most favourable outcome from the Fed. Driven by rate-cut hopes, the S&P500 price-to-earnings ratio has risen by 20 per cent since the December trough despite the escalation in trade tension between the US and China. For comparison, the index P/E ratio jumped 22 per cent during the 1995-1996 rate cut period. 

In short, the stock market is expecting too much that the Fed is unlikely to deliver. Economic momentum is slowing but not to the point where aggressive rate cuts are called for. The “insurance” rate cut, while perfectly possible, is unlikely to match the market’s expectations, which could leave room for a big disappointment and a sizeable retreat in stock price. 

Contributed by KOMSORN PRAKOBPHOL, head of TISCO economic strategy unit (ESU).


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