Fed Cuts Rates by 25bps, but US Stocks Slid as Powell Sowed Doubt on Future Rate Cuts

Despite a 25bp rate cut by the Federal Reserve at its 31 July FOMC meeting, markets gyrated as Fed Chairman Powell failed to provide clear dovish commentary on the interest rate outlook. Citi analysts retain the view that supportive domestic data may mean that the FOMC may not embark on a full cut cycle and expect just one further 25bp in 2019, most likely in September.

Fed Action

• At its 31 July FOMC meeting, the Federal Reserve (Fed) cut its key policy rate by 25bp to a 2.0% to 2.25% range. Along with this first rate cut since the 2008 crisis, the Fed said it would end reductions in its lending to the US bond market (quantitative tightening) two months earlier, in August.

• While the Fed noted a generally positive US economic performance, it cited “implications of global developments for the economic outlook” and “muted inflation pressures” for the policy change. Yesterday’s action also saw dissent from two regional Fed presidents.

Market Action and Reaction

• With financial markets already poised for at least a 25bp point rate cut, markets initially absorbed the rate decision well, honing on the statement suggesting the Fed remains open to additional action.

• The calm was disturbed when Fed Chairman Powell termed the action a “mid-cycle adjustment” and said that “a lengthy cutting cycle is not our perspective”. He even noted that if the Fed were truly successful in extending the expansion, future rate increases could not be ruled out.

• Financial markets gyrated on these views – US equity indices fell over 1% overnight, yield on the 10-year note fell 5bps to 2.02%, and the US dollar index was up around 0.6%.

Citi’s Take: Benefits of Falling Rates Have Been Significantly Discounted in Broader Asset Values

• Market reaction highlights how much expected central bank easing has already impacted asset values.

• As Powell noted, protecting the expansion is now the Fed’s highest priority. While heightened easing expectations risk greater market volatility near-term, Citi analysts generally think that the Fed may be likely to succeed in “nudging” the US economy away from possible contraction with modest policy action, particularly if trade shocks are avoided.

• Citi maintains unchanged asset allocation – underweight equities, overweight bonds. Some degree of caution should be maintained. Within equities, Citi analysts overweight Emerging Asia. Within bonds, overweight US Treasuries, US investment grade and Emerging Market bonds.