Will the first cut be the deepest?

The US Federal Open Market Committee (FOMC) is expected to meet on June 18 and June 19 to decide if at all a rate cut is on or will the members decide to remain uncommitted on the direction of the US interest rates after taking that neutral view the last round.

In the last FOMC meeting in early May, the committee concluded that they remain patient on any rate moves as economic data showed robustness, while inflationary threat remains imaginary then. Hence, the Fed Fund Rate (FFR) was held steady at the 2.25-2.50 range.

After more than a month since the FOMC meeting, a lot has changed in the economic and the trade war between the US and China as well as markets in May. For example, the S&P 500 itself lost some 6.6% or US$4 trillion in value last month – justifying again the view of “sell in May and go away” while the trade war between US and China has now escalated to the extent we are seeing not only more goods are subjected to tariffs but the tariff rate too has now been raised to 25%. Not to be missed out, President Donald Trump is also set to impose tariffs on goods imported from Mexico while against India, he is expected to remove the preferential trade status granted – a move that will potentially see some US$5.6bil worth of Indian goods exported to the US to be subjected to duties.

Any nation that is subjected to trade barriers by a powerful nation like the US cannot afford to lie low and let the mighty US take advantage. These nations will rise and take counter measures to protect themselves as failure to do so would be viewed as a weak country in the eyes of international community. Effectively, no nation wants to be branded as a weak nation as the US continues its bullying agenda.

We all know that trade war is lose-lose game and the real losers are consumers. Question is why has the US chosen this path in the name of balancing its trade deficit. The answer perhaps lies in the US political scenario. Trump knows that his popularity is falling and what better way to improve his approval rating by making Americans feel that they are paying a high price for the trade imbalance that the US is having with other nations in the form of job opportunities, investments and economic growth. With wider domestic support, Trump is also expected to announce that he will run for the 2020 presidential race and for the second term in office.

With the escalation in trade war between the US and the rest of the world, markets don’t like what it is seeing and we are now observing another round of flight to safety. While the FOMC maintained rates in its last meeting and signalled that rates will remain unchanged for now, market is giving another clue altogether. The US 10-year treasuries has dropped 41bps to 2.12% as at Thursday and is now lower by 111bps from its high of 3.23% in October last year when at that point the effective FFR was at 2.20% - giving a positive yield spread of 106bps then against the current scenario of a negative spread of 26bps.

The two-year and three-month US treasuries too have declined sharply with the two-year down to 1.88% - lower by 46bps since FOMC’s last meeting and is now down by 109bps from its high of 2.97% in November last year. The three-month US treasuries yield too have declined but not as steep as the longer end. The three-month papers were last seen at 2.30%, down about 12bps since start of May and just 15bps lower than its 52-week high of 2.45%. With the short-end dropping at a slower pace than the longer end, its natural we are now seeing an inversion in yield.

With 10-year at 2.12%, five-year and two-year both at 1.88% and three-month at 2.30%, we have an inversion on the 10-year minus three months of 18bps, and both the five years and two years minus three months at 42bps each. The 10-year minus two-year – a widely accepted inversion theory to predict a potential recession remains positive at 24bps. With the FFR is at 2.25-2.50% (or at an effective rate of 2.38%) we have an inversion of rates at all levels – from three-month treasury (at 8bps) right up to 10-year (at 26bps) as the US treasury rates across tenures are lower than the short term overnight rates charged by a bank with surplus reserves to other banks in deficit.

What does this mean to markets expectation on Fed Fund Rate expectations? In the futures market as of Thursday, the FFR contracts are implying an 84% chance that the Fed would reduce interest rates by as much as 50bps by year-end, implying two rate cuts is on the horizon – one in September and the other in December this year.

Should they? A look at the chart of US 10-year treasuries less the FFR suggest, that typically, the rate is positive.

Over the past 20 years, charts depicting the two lines suggest that whenever the reading turns negative is at a time when the Fed is done with raising rates and the economy begins to slowdown or worse, contract. This results in the 10-year yield trending lower, resulting in the differential between the 10-year and the FFR narrowing. By the time the differential between the 10-year US treasuries and the FFR reaches closer to negative 100bps or more, the Fed begins to cut rates. The differential will remain in negative territory even after the first few cuts and only turns positive when the economy enters into a recession as investors see potential recovery of the economy in six-nine months ahead.

This can be seen from the graph (left) which depicts the relationship between the 10-year US Treasuries and the FFR.

What can we conclude from here? The Fed is unlikely to cut rates just yet as the negative spread between the 10-year and US treasuries has not reached its peak although the spread is widening. Hence, perhaps, the market’s view that a move is imminent is a right one and a rate cut can be expected as early as September 2019 and another one by December 2019. Should economic data deteriorate further or if inflation reading turns weaker, there is even a likelihood that the Fed may cut outside its FOMC scheduled meeting or a more aggressive cut of 50bps in September 2019. So, we may see a deeper first cut rather than a sustained and measured cut of 25bps each.

Will we go into a recession?

The 10-year minus US FFR is less of predictor of a looming recession than the 10-year less three-month as a benchmark.

Hence, the spread between the 10-year and three-month has some room to go still before the probability of recession rises even more. The typical spread between these two maturities is between -60bps and -80bps before we see a likelihood of a recession six to 12 months down the road.

We are now at -18bps and counting. Recession may be looming but not on the horizon just yet.