A clear dovish tone was prevalent across Fed Chair Powell’s testimony and Q&A on the morning of 10 July, as well as in the June FOMC minutes released later in the afternoon. Powell stated that “uncertainties… continue to weigh on the US economic outlook,” and more importantly did not push back against market expectations of a July cut in his language.
All this signals that the G20 trade truce and robust payroll number in the week before did not dissuade the Fed from their belief that a set of imminent rate cuts is necessary to insure against downside risks.
Our baseline scenario is that the Fed will cut rates by 25 bp in July. A 50 bp cut is less likely but cannot be ruled out. Another 25 bp cut will likely follow in Sep since a single cut alone would not help the Fed achieve much. Historically, insurance rate cuts by the Fed have been around 75 bps in total, so we could expect another in Dec or later although the timing and magnitude will depend on further developments in trade and the economy.
If the Fed does cut this month, it will be ahead of the curve in terms of risk management as it will be doing so against a backdrop of a healthy labor market and the S&P500 hitting record highs, as opposed to waiting until clearer stresses emerge.
One perspective is that this represents sound pre-emptive risk management: Cutting rates later when the labor market is deteriorating might be ineffective and too late. The argument for pre-emptive insurance further strengthens if we consider: 1) the skewed downside risks posed by persistently weak inflation and expectations below its 2% target; 2) with Fed Fund rates at 2.5%, the Fed does not have much room to ease if it waited until it saw the whites of eyes of a recession, unlike in 2001 and 2007 when the Fed Funds rate were at 6.5% and 5.25%, respectively.
Unsurprisingly, risk asset rallied in the direct aftermath of Powell’s testimony. An accommodative Fed comprises a key tailwind for risk assets, especially so given that the ECB and other central banks would likely follow the Fed’s lead, setting off a global easing cycle down the road.
One question now is: how thin is the ice under this rally?
Since 1994 (when the Fed began to announce rate decisions under Greenspan), the Fed has put forth four sets of rate cuts (1995, 1998, 2001 and 2007), and history shows that rate cuts tend to be supportive of risks assets over the near term, and have a longer positive effect (as in 1995 and 1998) if recessionary pressures do not emerge, which is our base case. While we are cognizant of persistent risks from trade and growth which warrants careful watching and will translate to higher volatility ahead, we see the overall landscape for risk assets as a constructive one.
Exhibit 1: Bank of Singapore Tactical Asset Allocation (TAA)
Source: Bank of Singapore
Beside a move up for US equities yesterday, we also saw waning US dollar strength (DXY down 0.5%), and importantly this trend, if continued, will be supportive of EM currencies and assets as they see a further respite from US dollar pressure and a more conducive growth environment due to monetary accommodation.
In fixed income, we like high-yield (HY) bonds, particularly emerging market (EM) HY and selective bonds in the Chinese real estate space which will benefit from lower rates, a relatively more positive environment for growth, and also provide sought-after carry in a reach-for-yield environment. For equities, we are overweight US and Asia ex. Japan, particularly Singapore, Indonesia and Taiwan. In China, we prefer sectors related to domestic consumption, infrastructure and construction, which should benefit as fiscal stimulus further accelerates ahead.Disclaimer applicable to recommendation
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