Bonds Commentary

We Got A Cut, Now What?

August 2019

The Federal Open Market Committee (FOMC) gave the market what it desperately desired - a rate cut - to close out July. The quarter-point reduction in the Fed funds rate was the first cut since the depths of the global financial crisis in 2008. Markets have long been expecting and pricing-in a rate cut, the only question was the magnitude of the move. Leading up to the meeting, futures markets placed just an 18 percent probability on a more drastic half-point cut, while most bet their chips on a quarter-point “insurance” cut, which proved to be correct. In conjunction with the rate cut, the FOMC also announced the end of “quantitative tightening,” central bank jargon for allowing securities to roll off of its balance sheet without reinvesting the proceeds, two months earlier than previously expected.

The outcome of the FOMC meeting was broadly in-line with expectations, but as has been the case a few times since Jerome Powell took the helm, communication surrounding the move either confused or downright disappointed market participants. Chair Powell sparked a sell-off in stocks and buying in long-term Treasury bonds by stating that the rate cut was simply a “mid-cycle adjustment” and not the start of a series of cuts during his post-meeting press conference. This wasn’t what investors wanted to hear as futures markets anticipated an additional half-point of easing before year-end, and Powell’s comments threw cold water on those hopes and dreams.

A potential failure by the FOMC to meet Mr. Market’s lofty and, in our view, unreasonable, expectations for rate cuts sat atop our list of concerns for the past few months, and that fear appears to have now come home to roost. After some miscommunication leading up to the July 30-31 meeting, Chair Powell attempted to avoid backing the FOMC into the rate cut corner again over the coming months, and while the market took his comments to mean “one cut and done,” Chair Powell said no such thing, and left the door open for additional policy action down the road. An additional quarter-point cut in September is our forecast, while the market believes 50 basis points of cuts remain in the cards prior to year-end.

The 10-year U.S. Treasury yield dipped down to 1.74% at the time of this writing – 32 basis points below where it closed July 30, and 27 basis points below the yield on 3-month T-bills. Investment-grade and high yield corporate indices have exhibited few signs of stress up to this point, a positive gauge of the health of corporate issuers and the economic backdrop, broadly speaking, as well as a representation of the current ample liquidity environment. U.S. dollar denominated emerging market debt remains an attractive area to allocate capital, both from a yield and diversification perspective, but one must be cognizant of risks when allocating to the space. Total return expectations should be scaled back given the recent drop in yields, but we see little reason to alter our portfolio positioning at the present time. August is setting up to be another profitable month for investors in higher quality fixed income, but investor positioning in Treasury bonds is aggressive, and bond yields could reverse sharply higher on any positive news - or perhaps a tweet - surrounding U.S./China trade.

Source: Bloomberg, Factset


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