Unfortunately, even though we believe that Powell will sound more dovish than at earlier meetings, we still maintain that there is a real risk that the Fed won’t be as dovish as the market expects it to be.
As a matter of fact, we don’t believe that data are as bad as they seem. There may be reason to loosen monetary policy when considering inflation as it is well anchored or even trending lower. However, other data indicate that a rate cut might be premature. For example, unemployment is near its natural rate and wages are still supported. In addition, we must remember that there is still uncertainty surrounding how tariffs will impact inflation, which makes an argument for the Fed to be more patient and wait for more data.
Instead of cutting interest rates the Fed might use other tools such as tapering the quantitative tightening to end its balance sheet reduction, thus allowing time to wait for more data and delay interest rates cuts. After all, if you can only cut interest rates eight times from current levels, you don’t want to waste this tool when you don’t really need it.
We believe that if the Fed sounds as dovish as the market expects it to be and prepares for a rate cut as early as next month, this can only mean that the Fed has lost operational independence and is meekly toeing the White House line or that it has more information than the market has regarding a deterioration of the economy.
Either way, the news is not going to be positive and the fixed income market will react to both outcomes.
After the rally in US sovereigns the biggest problem at this point is that if the Fed does not deliver on market expectations there could be a sell-off, especially in the shortest part of the yield curve. We believe that the Fed will use neutral language to avoid provoking volatility in the market. However, if investors suspect that three rate cuts are not realistic, we can expect some adjustments in bond valuations.
If that were to be the case, we believe that the shortest part of the curve would rise faster than the longer end, due to the fact that while investors would keep their investment in the longer part of the curve due to fears of a trade war and uncertainties regarding foreign policy, especially a confrontation with Iran, the short-term part of the curve at the moment is uniquely linked and dependent on central bank monetary policy. This might be the last element that may provoke the very much feared inversion of the US yield curve.