All eyes on central banks in the coming weeks
Looking ahead, we all know that the main market focus will be on central bank meetings at the end of the month. It will be the confirmation we are in a completely new monetary and economic paradigm where unconventional tools used after 2008 are becoming conventional tools in a world of very low neutral rates.
What is quite unique this time is that both the Fed and the ECB are ready to pull the trigger to act pre-emptively. Though there are more fundamental reasons for the ECB to act (risk of recession in Germany and subdued inflation), it is more questionable for the Fed. The macro case for rate cuts in the United States is debatable, especially if we consider that the Fed is first and foremost “data dependent”. The economy is in a rather good shape, but it seems that the Fed’s goal to loosen monetary policy is motivated by other considerations:
- In his speech early this week, Powell implicitly confirmed that the Fed has certainly overtightened this cycle and is now looking to reverse the December hike which looks increasingly like as a monetary policy error.
- The Fed has always taken into consideration the global context, but it seems this time it is playing a dominant role. In his short testimony to Congress, Powell used the words uncertainties and risk many times, putting very special attention on global factors, which constitutes a change compared to previous cycles.
At the time of writing, the Fed funds futures price a 70% chance of a 25bp cut and a 30% chance of a 50bp cut on July 31st. Our view is that the Fed will cut rates by 25bp this month and, if needed, will act again in September. We have received a lot of questions from clients regarding the impact of the expected rate cut. The conventional wisdom is that the first rate cut is bullish for the stock market, but it has not always been true, especially taking into consideration the last two first Fed cuts. In addition, there are two factors playing against a strong rally: the 25 bp cut has already been priced in and, more importantly, in a QE world, it is probably useless to predict market reaction based on pre-QE history.
Finally, as it was the case many times over the past decade, it is likely that the Fed and the ECB will try to avoid monetary policy divergence that could have a negative impact on exchange rates while we are on the breach of a currency war triggered by the Trump administration. The latest ECB minutes mentioned a “broad agreement” among the Governing Council to be ready to ease monetary policy again, referring to “strengthening forward guidance, resuming net asset purchases and decreasing policy rates”. We see a policy move more likely on September 12th than on the next policy meeting on July 25th. It could be officially motivated by subdued inflation, but the primary concern will be the deteriorated economic outlook in Germany. At first, we expect a slight adjustment in interest rates, by moving the deposit rate further into negative territory. However, as it is unlikely to have a significant impact, the ECB will need to apply more drastic measures, especially exiting limits of its QE program by rising the ownership ceiling for bond issues to 50% from the current 33%%. This is the era of QE infinity.