The Fed cuts to the chase  

Brian Nick

The last week’s market highlights:

Quote of the week:

“The bottom line is, the economy is in a very good place, and we want to use our tools to keep it there.” – Federal Reserve Chair Jerome Powell    
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Midyear Outlook :
  • U.S. economy: Late cycle but no recession
  • Global economy: Still looking for a bottom    
  • Policy watch: Easy monetary policy to offset restrictive trade policy  
  • Fixed income: Volatile interest rates but no breakout in either direction 
  • Equities: Get defensive, stay invested 
  • Asset allocation: No longer “risk on,” but still prefer emerging-market bonds  

Policy watch: When Jerome Powell speaks, markets listen   

In his semiannual testimony to Congress on July 10-11, Federal Reserve Chair Jerome Powell all but confirmed that the Fed will cut interest rates at its July 31 meeting. The tipoff came from Powell’s prepared remarks. He noted that crosscurrents from global growth and trade, which had been moderating in May, “have reemerged” and “continue to weigh on the U.S. economic outlook.”  
During his Q&A with House members, Powell added that the deterioration in manufacturing activity and levels of global trade, along with lingering uncertainty on trade issues, hadn’t reversed to the Fed’s satisfaction. And he noted that June’s strong U.S. jobs report had failed to change the Fed’s outlook.    
Fed funds futures, used by traders to bet on the path of short-term interest rates, had already reflected a 100% chance of a 25-basis-point (0.25%) rate cut in July. But markets viewed Powell’s remarks as so dovish that the odds of a 50-basis-point reduction soared from 0% on July 9, the day before his testimony began, to a whopping 24.5% the next day. (We deem such a move unlikely.) The odds of a second and third cut before year-end also rose substantially.   
We don’t think the Fed’s increased willingness to loosen policy stems from an erosion of independence from the White House or other branches of government, as some commentators have suggested. Rather, Powell and his colleagues have become more tethered to market sentiment. And by relying on trade uncertainty and global growth to justify a July rate move, the central bank has, to a degree, lost control of monetary policy. After all, the Fed’s dual mandate—price stability and full employment—looks close to being fulfilled.
At the same time, with investors banking on a cut, the Fed would lose credibility with markets if it were to hold rates steady—even if that’s the right policy and the market is wrong. Last week’s economic data releases actually strengthened the case for continued Fed patience: Inflation, as measured by June’s core consumer price index, topped forecasts, and initial jobless claims fell to a three-month low. Neither of these readings supports a more dovish stance. 
But if there’s a disconnect between firming economic data and increasingly dovish policy, equity investors aren’t complaining. The S&P 500 Index has risen in five of the past six weeks, bringing its 2019 return to more than 21%, and it closed above the 3,000 level for the first time on July 12. Its last such “millennial” milestone took place five years ago, in August 2014, when it first crossed the 2,000 threshold. With equities no longer cheap, and corporate earnings growth likely to weaken this year and next, it may well take more than five years to tack on the next 1,000 points.

Global economy: Governments and central banks to the rescue 

Since the Fed has been taking the temperature of the global economy as it considers cutting interest rates, it’s worth examining what’s been ailing the patient. Here are some symptoms:
  • U.S. business and housing investment slowed in the second quarter.
  • Manufacturing activity, as measured by June purchasing managers’ indexes (PMIs), contracted in Japan, the eurozone and China. The U.S. manufacturing PMI fell to a near three-year low in June but remained in expansion territory.
  • Global trade growth weakened in the first quarter and is likely to remain soft in the second quarter, according to data published by the World Trade Organization. One measure, the World Trade Outlook Indicator, hit its lowest level since 2010.
But is the global economic backdrop really that dire? Perhaps not. While manufacturers have been struggling, service-sector businesses have been holding their own. June PMIs revealed that:
  • U.S. nonmanufacturing activity dipped slightly but stayed well above the 50 mark (55.1) separating expansion from contraction.
  • Eurozone service-sector growth hit an eight-month high of 53.6.
  • China’s service sector remained solidly in expansionary mode (54.2).
These positive signs, though, have not been enough to avert a global economic slowdown, and steps are being taken to jumpstart growth. For example, China’s central bank has already beefed up efforts to stimulate its economy, and its government has increased fiscal stimulus, primarily in the form of tax cuts. These actions preceded forecasts for the Chinese economy to register its weakest quarter of year-on-year GDP growth (6.2%) on record.
Meanwhile, the European Central Bank (ECB) seems prepared to open its stimulus toolkit. Minutes from its June meeting indicated the ECB “should stand ready to ease monetary policy further by adjusting all of its instruments.” Possible measures include extending forward guidance by committing to maintain ultra-easy policy for longer than expected, restarting its bond-buying program and decreasing policy rates. With the Fed signaling that a U.S. cut is forthcoming, we think the ECB would be taking a risk by standing pat or by failing to offer less-than-generous support to markets. That could send the euro higher versus the dollar and suppress inflation that is already stubbornly low—a scenario the ECB is trying to avoid.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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