Dollar Mixed Ahead of FOMC Decision

Some Thoughts on the Fed’s Surprise Cut

The Fed just surprised markets with a 50 bp intra-meeting cut.  The vote was unanimous, and the Fed said it will continue to act as appropriate.  This would seem to open the door for further cuts, but front-loading easing may also mean that they will ultimately need to do less in this mini-cycle.  In this piece, we discuss what the Fed can do, what it can’t do, what it should do, and what it will likely do.

RECENT DEVELOPMENTS
The Fed just surprised markets with a 50 bp intra-meeting cut.  This was the first intra-meeting cut since 2008, during the depths of the Great Financial Crisis.  With an FOMC meeting scheduled for March 18, was this intra-meeting move really necessary?  If anything, the next two weeks would likely have provided more information for the Fed make a policy decision.  This move smacks of panic, especially since there were no obvious signs of financial stability risks warranting an emergency action.

Hopes for coordinated global stimulus have given markets a reason to be optimistic. Late Friday, Fed Chair Powell issued an unscheduled statement saying the Fed is monitoring the impact of the virus and will act as appropriate.  After Powell’s statement, the BOJ and BOE both followed suit with pledges to act as needed to ensure financial stability.  Today, ECB President Lagarde noted that it is “closely monitoring developments and their implications for the economy, medium-term inflation and the transmission of our monetary policy. We stand ready to take appropriate and targeted measures, as necessary and commensurate with the underlying risks.” But the bar is very high for any explicit coordinated action (Plaza accord style).

G-7 Finance Ministers and central banks held a call today to discuss policy coordination.  Nothing specific emerged.  The communique said that “G-7 finance ministers are ready to take actions, including fiscal measures where appropriate, to aid in the response to the virus and support the economy during this phase.”  This is pretty much boilerplate language, so much so that it feels like a cut and paste from previous communiques with a bit added about the virus.

Broad-based monetary easing is on the way.  Overnight, Reserve Bank of Australia and Bank Negara Malaysia delivered 25 bp cuts.  Bank of Canada is expected to cut 25 bp tomorrow, and expectations are rising for cuts from the European Central Bank, Bank of England, and Reserve Bank of New Zealand.  Other EM central banks are also likely to follow Malaysia in cutting rates.  Yet we hesitate to call this coordinated.  Most policymakers are focused on boosting their domestic economies and are simply acting accordingly.  This was a similar dynamic that was seen during the Great Financial Crisis.

Fed easing expectations remain elevated even after today’s surprise cut.  Next FOMC meeting is March 18 and WIRP suggests another 25 bp cut is fully priced in.  Another 25 bp is nearly fully priced in by the June 20 meeting and another 25 bp cut is nearly fully priced in by the January 2021 meeting.  This would take the Fed funds target range down to 0.25-0.50%, putting it within a hair’s breadth of the crisis-era low of 0.0-0.25%.

WHAT CAN THE FED DO?
The Fed can cut rates to address tighter financial conditions.  According to the Bloomberg measure, US financial conditions have tightened sharply in the past week.  Yet let’s put matters into perspective.  At -0.77 currently, US financial conditions have tightened from the recent peak of +0.98 on February 18.  However, conditions remain much looser by far than what we saw during the Great Financial Crisis.  Yet the transmission channel to the wider economy remains broken (see below) and so looser financial conditions due to Fed rate cuts are unlikely to have any significant direct impact on the economy.

The Fed can cut rates to calm equity markets and boost confidence.  That is what the Fed ultimately did last year after markets went haywire after its last 25 bp hike in December 2018.  The Fed’s messaging did a complete 180 in H1 2019 ahead of the Fed’s first rate cut July 31.  That was followed by another cut September 18 and another cut October 30, which completed the so-called “mid-cycle adjustment.”  The yield curve, which had inverted in May and again in July, finally moved back to a positive slop in October.  The curve inverted again in February and today moved back to positive slope.

WHAT CAN’T THE FED DO?
The Fed can’t fix broken supply chains.  This is mostly dependent on China and its efforts to get factories up and running again.  Anecdotal reports suggest factories are operating at around 60-70% of capacity.  While this is a good start, more must be done.  But domestic firms won’t invest or hire workers as long as the supply chain is broken.

The Fed can’t get people to go out and spend.  So-called “Social Distancing” has taken hold in countries that have seen the virus spread.  That means no one is going out to eat or to shop.  The US is not there yet but it seems to be only a matter of time.

WHAT SHOULD THE FED DO?
We believe the Fed should have remained calm and maintained its wait and see approach for now.  It is simply too early to know how badly the US economy will be impacted by the virus.  Instead, the Fed cut intra-meeting and validated market expectations.  In fact, the market now wants even more as it is pricing in a total 125 bp of easing compared to 100 bp prior to today’s cut.  If the Fed were to cut rates that aggressively, then it would not have any ammo to address a situation in which monetary policy could actually have an impact on the economy.

The Fed should pledge to keep US financial markets operating normally.  That means possibly continuing its T-bill purchases beyond Q2, or adding liquidity as needed by repo operations if funding markets were to go haywire again.  This is a fairly low cost measure and could help sooth any market concerns about the health of the US financial system.  So far, there have been no issues seen in US funding markets, which suggests that the financial plumbing is working for now.

WHAT WILL THE FED LIKELY DO?
Chair Powell already bent the knee to markets last year.  Recall that he was forced by the markets to walk back the Fed’s final hike of the cycle from December 2018.  The so-called “mid-cycle adjustment” saw rates cut 25 bp each in July, September, and October 2019.  Now, he has bent both knees.  The optics are particularly bad (again), with the emergency cut coming after President Trump called for lower rates.

What can we expect at the March 18 FOMC meeting?  We expect the Fed to deliver another 25 bp cut.  New staff forecasts will be released.  Median growth forecasts were unchanged at the December meeting at 2.0% in 2020, 1.9% in 2021, and 1.8% in 2022.  Downside risks have clearly increased and so we are likely to see some downward revisions to the US growth outlook for this year.

The Dot Plot projections will be updated but remain as worthless as ever.  The December Dot Plot saw no cuts in 2020 and yet here we are.  Going further back, the June 2019 Dot Plot suggested no cuts in 2019 and then the Fed went ahead and cut on both July 31 and September 18.  The September Dot Plot suggested no more cuts in 2019 and then the Fed cut on October 30.  Let’s just get rid of the Dot Plot as part of the Framework Review.

Powell gave a press conference after the surprise.  As expected, he re-confirmed that the Fed stands ready to cut rates again if needed.  Powell noted that risks to the outlook had “changed materially” due to the spreading impact of the virus.  Other than that, he revealed very little beyond confirming the market’s dovish take on the Powell Fed.  The Beige Book for this meeting will be released tomorrow and is already hopelessly outdated.

A BRIEF HISTORY LESSON
The last global easing cycle took place during the Great Financial Crisis.  The Fed started its easing cycle with a 50 bp cut to 4.75% in September 2007.  That was quickly followed by 25 bp cuts in October and December.  The Fed started to get very serious, with a 125 bp cut to 3.0% in January 2008, followed by a 75 bp cut in March and a 25 bp cut in April that took the Fed Funds rate to 2.0%.  The Fed didn’t move again until October, when it cut rates 100 bp to 1.0%.  The last cut saw the Fed move to a target range for Fed Funds of 0.0-0.25% for slightly over 500 bp of total easing.  Rates stayed there until December 2015, when Fed Chair Yellen delivered the first hike of the tightening cycle, moving the target range to 0.25-0.50%.

Other major central banks followed suit.  The next most aggressive were Bank of England and Reserve Bank of New Zealand, as both delivered 475 bp of total easing during the crisis.  Next was Bank of Canada with 400 bp, Reserve Bank of Australia with 325 bp, Riksbank with 275 bp, European Central Bank and Norges Bank both with 250 bp, Swiss National Bank with 175 bp, and Bank of Japan with only 20 bp.  Several of these banks went on to cut rates even lower, but those were seen after the Great Financial Crisis had already ended.

ECONOMIC OUTLOOK
The US economy is doing better than anticipated so far in Q1.  Q4 GDP growth was unrevised at 2.1% SAAR, and Q1 is growing at a similar pace.  The Atlanta Fed’s GDPNow model estimates Q1 GDP growth at 2.7% SAAR vs. 2.6% previously.  Elsewhere, the NY Fed’s Nowcast model estimates Q1 GDP growth at 2.1% SAAR vs. 2.0% previously.  Both were updated last Friday.  February data have come in strong, but the risk is that March and April will show a sharp drop-off as the impact of the coronavirus begins being felt in the US.  Still, we remain confident that the US economy can avoid recession and is likely to be the most resilient in the coming months.

INVESTMENT OUTLOOK
The dollar has softened as Fed easing expectations have picked up.  It is down today but holding up relatively well in light of the surprise cut.  DXY is down nearly 3% from the February 20 high near 99.91 and is on track to test of the December 31 low near 96.355.  The euro tested the $1.12 area and appears on track to test the December 31 high near $1.1240.  Elsewhere, sterling remains heavy near $1.28, while USD/JPY remains heavy near 107.50 despite a bounce off the 107 low.

We maintain our strong dollar call whilst wholeheartedly admitting that the Fed is making this a tough one to maintain.  Going forward, much will depend on how other central banks respond, as well as on how aggressive the Fed really is prepared to cut.  There should also be some returning safe haven bid if and when the virus news stream goes negative again.  We maintain our view that the US economy remains best-positioned to deal with the effects of the coronavirus and that the dollar should ultimately benefit from this.

The US yield curve is no longer inverted, at least for now.  At +7 bp, the 3-month to 10-year curve is not inverted for the first time since February 17.  The US 10-year yield hit a new record low today near 1.05%.  This suggests that recession risks have eased, though of course it’s too early to sound the all clear.  The US has not yet felt the sort of quarantining, shutdowns, and social distancing that China and other nations have felt.

We downplay this current bout of optimism as we believe that the prospects of aggressive Fed or even globally coordinated easing are not enough to offset the growing headwinds to the global economy.  Until the scope of the virus outbreak is known, we see no reason to get optimistic on global growth prospects.  As such, we would look to fade this rally in equities, EM, and commodities.  We would look to stay overweight the Swiss franc, yen, and core bonds.  The dollar should also eventually recover, though we see scope for further near-term weakness.