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Economists Expect the Fed to Cut Interest Rates. Markets Already Have.

By: Sean P. Smith, CFA

June 18, 2019

  • The Federal Reserve will announce its decision on interest rate policy tomorrow.
  • After raising rates throughout all of 2018, markets now anticipate the Fed to reverse course and begin cutting rates – if not at tomorrow’s meeting then very likely in July.
  • Expectations for economic growth in the remainder of 2019 have moderated, and interest rates throughout the economy have already fallen substantially as a result.
  • While the direction of Fed policy is extremely important, in many respects markets have been well ahead of the Fed this year.

The interest rate policy set by the Federal Reserve can have an immense impact on financial markets. The steep stock market selloff in late 2018? At least in part due to fears regarding the Fed’s ongoing policy of raising interest rates – the Fed was trying to prevent the economy from overheating, but many investors worried that they’d halt economic growth altogether. The quick market rebound in early 2019? Largely a reflection of investor relief after the Fed signaled the adoption of less-restrictive rate policy. 

So, it is with great anticipation that investors await tomorrow’s Federal Reserve interest rate decision. After spending all last year hiking interest rates, conditions and expectations have now completely reversed.

Investments reflecting interest rate expectations indicate that, as of this morning, markets are pricing in a 24% chance that the Fed will cut its primary targeted interest rate by a quarter point tomorrow. A month ago, that probability stood at only 10%.

By the next Fed meeting, in late July, however, markets are pricing in more than a 90% chance of at least one cut to the Fed’s targeted interest rate. Regardless of the exact timing, the market is clearly expecting the Fed to take action soon, and to continue moving in that direction throughout the remainder of the year. 

While speculation about the Fed remains rampant, something interesting has happened out in the real economy – interest rates have already fallen. Substantially.

Although U.S. economic growth in the first quarter of the year remained solid, market expectations going forward are for a slowing rate of growth. While economic output grew more than 3% in the first quarter, economists are anticipating growth rates closer to 2% for the remainder of the year. The broad declines in interest rates over the last several months reflect these expectations.

Homebuyers have certainly noticed the change – from a recent high near 5% in late 2018, the average rate on a 30-Year fixed rate mortgage has fallen to 3.8%, near a two-year low. The lower rates offers support to the housing market, and the chance for some recent homebuyers to unexpectedly refinance their still-new mortgages.

Corporate borrowers have also benefitted from lower rates. Companies with pristine investment grade credit ratings – AAA borrowers – have seen yields on their debt fall a full percentage point, from just over 3.8% in late 2018 to 2.89% today. That’s lower than at any time since late 2017.

Companies with a BBB rating – the lowest level of “investment grade” credit – have seen a similar impact, with yields falling from more than 4.8% in November 2018 to 3.75% today.

And companies with weaker credit ratings have benefitted even more. The yields on what used to be called “junk bonds” – today more often euphemistically called “high yield”, regardless of how high the yield actually happens to be – have moved from more than 8% in December (amid the stock market selloff) to 6.15% today. For perspective, during the early 2016 stock market pullback, these yields briefly eclipsed 10%, and bottomed out around 5.5% in the calm of 2017.

For companies raising new debt capital, or refinancing outstanding bonds, those rate changes can make a meaningful impact on annual interest expenses. And saving on interest expenses fall directly to bottom line profits.

The declines in rates haven’t been limited to borrowing costs, however. Inflation expectations have fallen meaningfully this year. Two important metrics, which track market expectations for inflation over the next five years, and for the five-year period starting five years from today, are both now well below the Fed’s long-term inflation target of 2%.

The expected rate for the next five years is now below 1.5%, after having climbed to a recent peak above 2.1% in May 2018.

Longer-term inflation expectations have dipped to a two-year low, below 1.8%, after having exceeded 2.3% in early 2018.

The lower inflation expectations make it significantly more likely that the Fed will be spurred to cut its targeted policy rates, and the fear of an overheating economy and the risk of spiking inflation has all but disappeared.

Finally, the trend of lower yields has had a significant impact on U.S. Treasury rates. The yield on a 5-year US Treasury security has fallen from a high of more than 3% in November of last year to just 1.85% today. Likewise, the yield on a 10-year Treasury has fallen from nearly 3.25% down to 2.1% over the same period.

The likely upcoming series of cuts to the policy rate will be meaningful, but in many respects, the markets have been well ahead of the Fed this year.


Citations:

CME FedWatch Tool: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US, June 18, 2019.

ICE Benchmark Administration Limited (IBA), ICE BofAML US Corporate AAA Effective Yield [BAMLC0A1CAAAEY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A1CAAAEY, June 18, 2019.

ICE Benchmark Administration Limited (IBA), ICE BofAML US Corporate BBB Effective Yield [BAMLC0A4CBBBEY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A4CBBBEY, June 18, 2019.

ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Effective Yield [BAMLH0A0HYM2EY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY, June 18, 2019.

Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIE, June 18, 2019.

Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIFR, June 17, 2019.

Board of Governors of the Federal Reserve System (US), 5-Year Treasury Constant Maturity Rate [DGS5], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS5, June

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