History Shows Traders Get What They Want With Fed Rate Cuts

(Bloomberg) -- As the age of the disruptive tweet lays waste to much of the market’s conventional wisdom, at least one truth holds: The Federal Reserve decides when to hike, and the market decides when to cut.

The past quarter-century shows that when Fed easing is at least 50% priced in days before a policy decision -- as it is for the Sept. 18 meeting and beyond -- the central bank has always reduced rates, according to data compiled by Bloomberg. U.S. President Donald Trump, who last month called for at least 100 basis points of cuts, may well envy such a track record.

If Fed Chairman Jerome Powell wants to break with precedent and convince traders that a quarter-point cut in two weeks is no fait accompli, he has a last chance to say something game-changing Friday in Zurich. The economic backdrop suggests he won’t.

The nation’s manufacturing activity just contracted for the first time since 2016, and the Treasury yield curve inverted this year, a move that’s preceded every recession since the 1960s. Any disappointment in Friday’s payrolls report could stoke fears that the global risks that the Fed cited as motivating its July rate reduction may have arrived in the U.S.

“The market has a good sense of telling us where the dangers are, what’s coming next,” said Jim Bianco, president and founder of Bianco Research LLC in Chicago. “The funds rate is the single highest interest rate in the developed world right now -- the market is saying that the funds rate’s too high.”

While the central bank always delivers on anticipated cuts, data going back to 1994 -- when the Fed first started announcing a target rate -- show it doesn’t always obey traders. As the Fed dramatically eased during the 2008 financial crisis, hikes were priced in -- but, since markets were haywire at the time, that can probably be ignored.

During the tightening cycle of 1994-95, then-Chairman Alan Greenspan confounded market expectations by standing pat on several occasions and hiking more aggressively than anticipated on others. A little more than five months after the final rate increase, the Greenspan Fed delivered a short burst of cuts to secure what was to become a record economic expansion.

That mid-’90s episode is relevant today. The Fed raised rates from 2015 through last December, and cut in July in what Powell described as a “mid-cycle adjustment.” But Powell faces a significant hitch in his efforts to protect this historic growth cycle as global trade slumps. Unlike two decades ago, the market is not just expecting a cut, but quite a lot of them. And so the Fed is playing catch up, and some say its goal may be undermined by paying too much heed to the market’s demands.

Distortion Risk

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That is, policy makers risk getting dragged by an apparent consensus on as many as three more cuts this year. That could set up bigger problems, such as excessive leverage or asset price bubbles. Goldman Sachs Group Inc (NYSE:GS). economist Jan Hatzius noted twice in recent weeks that the role of markets in the Fed’s thinking appears to have become larger, if not distorted. He invoked Greenspan’s successor, Ben Bernanke, who in 2004 described policy that strives too hard to meet market expectations as a “hall of mirrors.”

“We run the risk of being in that echo chamber,” said Tim Horan, the New York-based chief investment officer of fixed income at Chilton Trust Co., a $5 billion money manager. “The market has priced for cuts and the Fed has caught up to some of this because of their assessment of the risks, particularly the uncertainty of trade.”

But the Fed’s relationship with the market may be more complicated now -- in this era of low interest rates and less room to maneuver -- than it was 25 years ago. Its dovish pivots in 2019 are part of a campaign of clearer communications with the market, in order to deploy more policy levers, to greater effect.

“This is the way they think central bank communications ought to work,” said Lou Crandall, economist at Wrightson ICAP (LON:NXGN) LLC in New York. “Fed easing gets into the bloodstream faster if the market can anticipate it.”

Since the Fed started projecting the trajectory of interest rates in the dot plot, market expectations of the long-term average fed funds rate -- as measured by the 10-year OIS swap -- have never exceeded the central bank’s own projection.

Horan doesn’t think policy distortions are inevitable. He says central banks everywhere are operating with “a limited amount of firepower -- they’ve got to use it most effectively.” He said the Fed is “also understanding of its responsibility to lead the market here, in shaping those views.”

Some policy makers have expressed more concern than others about the market’s signals, in particular the yield curve’s inversion. Powell’s predecessor, Janet Yellen, last month expressed a view popular among some experienced hands, that this indicator may be less informative these days given how central bank policy has depressed yields over the past decade. St. Louis Fed President James Bullard is an outlier in suggesting that curing the curve should be a policy goal. Indeed, any effort to do so with deeper cuts might prove futile if asset purchases are again needed to stimulate the economy.

While Bianco is a big believer in cuts, he doesn’t see the Fed getting dragged all the way to zero from the current benchmark rate of 2% to 2.25%. He recommends the Fed stopping at 1%, at which point long-end yields should have lifted sufficiently to restore a more normal incline to the curve. Aggressive cuts to catch up with the market will increase the chances for growth to strengthen and inflation to rise, and then traders will be ready again for the Fed to start dictating to them about the need for tighter policy.

“But if you keep cutting rates slowly, you’ll never get there in terms of where the market is,” Bianco said.