July FED MEETING PREVIEW

We still see the Fed's expected July rate cut as fundamentally of a “recalibration” nature.

We expect the Federal Reserve (Fed) to cut its fed funds target rate range by 0.25%, and leave the door open for another cut later, after its two-day policy meeting ending on 31 July.

Chairman Jerome Powell has a lot of explaining to do as to why the Fed is making this rate cut, only six months after the last rate hike: this explaining could condition the path of future interest rate moves.

The Fed will also likely cut short the shrinking of its balance sheet, which was planned for September anyway.

Our view is that the Fed is mostly cutting rates out of fear of US yield curve inversion, to keep a buffer with (and stay below) the theoretical neutral rate and lastly, out of residual regret about December 2018’s rate hike. In other words, the notion of rate ‘recalibration’ is important.

But the Fed will likely argue it’s because of a hotchpotch of reasons, ranging from trade tensions, the weak global economy and the persistent tepidness of US inflation. In other words, it will defend the concept of ‘insurance’ against various risks as the Fed seeks to extend the elongated US business cycle. But the main risk is that Powell appears confused about what the Fed is doing.

The historical reference will be Alan Greenspan’s September 1998 ‘insurance’ cuts, although back then market liquidity issues were much more acute after a big hedge fund had failed.

Our baseline Fed scenario is for a second rate cut in September after the one on 31 July, and then rates on hold. But the more ‘unstructured’ and confused Powell’s explanations, the greater the risk of markets forcing the Fed into additional cuts in the coming year – after all where does ‘insurance’ cutting stop? The risks to our Fed rate path scenario are therefore mostly to the downside, even if we still do not expect a US economic recession in the near term.

Bigger picture, our view is that the Fed is in a ‘debt dominance’ regime where the sheer amount of debt in the US economy will continue to exert sizeable dovish pressure on the Fed. The Fed itself is slowly morphing into a debt defeasance structure, i.e. with the implicit role to help amortise all this debt in the system.

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