Cutting rates sooner rather than later
Today's news headlines:
- ‘Brexit bill for UK financial services reaches £4bn’. A report by Ernst and Young has revealed that UK financial services companies have already accrued £4bn in expenses. When comparing jobs moved to the EU in advance of Brexit, versus those required in the event of Brexit, figures suggest there are significant job cuts to come before October. (Financial Times)
- ‘Mueller to testify before Congress next month’. In response to a Congressional subpoena, Robert Mueller is expected to testify about the Trump/Russia Investigation. Despite previous reluctance to testify further on this matter, the Judiciary and Intelligence Committee Chairs wish to get his view on the record. (Financial Times)
Running out of tools
Concerns over the slowing global economy and the ongoing trade war between the US and China has led central banks around the world to consider monetary policy easing. The Reserve Bank of Australia (RBA) has already cut interest rates, while the Federal Reserve and European Central Bank (ECB) have recognised the need for future easing if the economic outlook fails to improve.
In a string of speeches last week, ECB Chief Mario Draghi confirmed his preferred tool of policy easing would be further quantitative easing (QE), and claimed the ECB has plenty of headroom to utilise its historically favoured policy tool. In another round of QE, the ECB would purchase assets to boost liquidity in the financial system. The EU top court could argue that breaching self-imposed limits on QE is merely printing money to fund governments—an act that is against EU law.
The ECB already has limited tools at its disposal since interest rates are at their lower bound, and further cheap lending operations have been announced. If additional QE is prohibited, the central bank may be forced to move deeper into negative interest rate territory—an unconventional move that Japan has already tested with questionable success.
Bottom line: In today’s highly integrated financial system, central banks rely on each other, to an extent, to ease policy in unison. If the ECB fails to contribute, the efficacy of monetary policy intervention could be undermined, causing confidence to remain low and concerns over global growth to last longer.
Has the market priced in too many Fed cuts?
Yesterday, Federal Reserve Chair Jerome Powell suggested that downside risks to the US economy have recently increased, supporting the likelihood of future interest rate cuts. Powell didn’t directly address the size of any potential rate cut but called for pre-emptive action to support economic activity, commenting: 'If you see weakness, it’s better to come in earlier than later'. The increased probability of a July rate cut pushed 10-year Treasury yields back below the 2.0% mark.
Driven by concern that inflation is stuck below the Fed’s 2.0% target, St. Louis Fed Chief James Bullard and Minneapolis Fed President Neel Kashkari both supported immediate rate cuts at last week’s Federal Open Market Committee (FOMC) meeting. Yesterday, Bullard made a case for a 25 basis point insurance cut, but stated that a 50bps cut 'would be overdone'. Markets will be closely watching June’s US jobs data, due on July 5th, as another poor reading will make a July insurance cut increasingly likely.
The Fed funds futures markets has priced in an 80bps interest rate cut by January, fuelling the recent US Treasury rally and forcing yields and the US Dollar lower. But does the math add up? Assuming there’s no ‘one and done’ 50bps cut, three cuts from the next five meetings would be needed, which is unlikely considering other Fed speakers have publicly questioned the necessity of policy change. Mary Daly told the New York Times that the Fed should wait to see if the data reverses over the next six weeks, while Thomas Barkin said he doesn’t know whether rates should be cut this year at all.
Bottom line: The realisation that the US bond market may have overshot the path of future interest rates could lead to a correction, pushing prices lower and yields higher. This eventuality will hinge on the Fed signalling a more cohesive and collective view on the US economy.
Yesterday’s shocking UK Realised Sales figure—the worst since the 2009—has nudged Sterling out of its sideways trade. The US Dollar appreciated very marginally as a result of Fed speaker comments, but the net impact on the pair is a gentle downward trajectory.
The Euro rally appears to have stalled at the trade-weighted 200-day moving average. With the Pound taking small losses, the pair is continuing its gradual downward trend. The Dollar is the primary driver of Euro valuation at the moment, so this afternoon’s Durable Goods Orders reading might have an indirect impact on GBP/EUR.
The momentum above the 200-day moving average hasn’t really materialised, but the technical level does appear to be supporting the Euro. Again, US data and geopolitical risks appear to be key drivers of the Dollar’s value, and consequently, the pair.