Fed View: We expect a quicker pace of cuts than markets and consensus – We and consensus look for a 25bp cut when the September FOMC meeting concludes tomorrow. Market pricing of rate cuts has declined somewhat over the past week, consistent with the broader move in bond markets surrounding last Thursday’s ECB meeting, however a 25bp cut is still around 90% priced in. Given this, the focus will naturally be on the quarterly projections and on Chair Powell’s press conference. Ultimately, we expect the Fed to deliver another two rate cuts by the end of the year after tomorrow’s cut, which is more aggressive than both consensus and markets – both of which expecting just one further cut this year. However, the difference is more about timing and pace, as both consensus and markets expect another cut next year, while we expect the Fed to pause.
Fed unlikely to signal much, leaving the data to drive markets – The question for this week is, to what extent the Fed will immediately signal more easing? Given the high degree of uncertainty over the trade war and the rather mixed tone to macro data, the FOMC will likely be reluctant to pre-commit and to signal too much at this stage; we expect the median ‘dots’ to foresee no further cuts this year, with one or two cuts next year. However, should our expectations for a further slowdown pan out, with weakness in manufacturing eventually driving a slowdown in consumption, we expect the Fed to respond to this quickly. As such, while the projections and Chair Powell’s press conference are unlikely to signal much near-term easing, markets will become more data dependent thereafter, and as the incoming data confirm that the economy continues to weaken, rate cuts will be repriced accordingly.
Why we expect growth to weaken further – Our view hinges on a further slowdown in economic growth, but what are the drivers of this? First, the manufacturing sector has yet to find a bottom, with the forward-looking ISM new orders index hitting a 7-year low in August, pointing to a further hit to already weak business investment in the coming quarters. Second, the weakness in manufacturing is leaving its mark on the labour market, with monthly average payrolls growth falling to +158k in the year to date – down significantly from +223k in 2018, and with much of this driven by the manufacturing sector. As such, while wage growth remains solid and is likely to remain so for the time being, declining jobs growth will weigh on aggregate income growth. Finally, government spending has been a significant growth boost for much of 2019 – contributing 0.6pp to the 2.6% annualised growth of the first half. However, this will taper off as we enter the new fiscal year in October, with the growth contribution probably close to negligible in 2020. Taken together, we expect these drivers to take GDP growth below trend over the coming quarters, and with a heightened risk of recession given the weak global backdrop.
Early decision on Standing Repo Facility is possible – Amid heightened funding market pressures, with the fed funds rate hitting the upper bound of the target range of 2.25% yesterday, the NY Fed conducted an unscheduled repo operation today. The FOMC might speed up a decision on a permanent Standing Repo Facility to alleviate funding pressures (it could also implement an additional IOER rate adjustment). The current pressures are reportedly linked to the settlement of mid-month Treasury coupon auctions, which have coincided with corporate cash withdrawals for quarterly tax payments. However, the Fed has been grappling with funding market pressures for over a year now, prompting a debate over the need for a permanent Standing Repo Facility to structurally reduce the demand for excess reserves (see the St Louis Fed’s proposal here for more details). (Bill Diviney)