The Case For The Fed Cutting Rates Back To Zero

On Wednesday evening, we spent a few minutes talking about the economy in the context of a January 6 note from Morgan Stanley, which found the bank reminding investors that even if the Fed succeeds in extending the longest expansion in US history, that’s no guarantee of a Trump win in November.

What’s interesting is how quickly the narrative has pivoted from August, when market participants (and, according to some polls, voters) were increasingly convinced that a recession was in the cards. Those fears were exacerbated by the inversion of the 2s10s although, as we explained at the time, that was something of a false optic created by convexity flows, as some market participants were forced to chase yields lower.

Fast forward to January and instead of discussing whether a likely US downturn will deep-six the president’s re-election bid, now we’re reminding ourselves that due to the small sample size and a number of other factors (e.g., Trump’s relatively lackluster approval rating), assumed economic strength doesn’t necessarily mean that the election result is a foregone conclusion.

Read more: Morgan Stanley: A Good Economy Does Not Guarantee Trump’s Re-Election

To be sure, it’s understandable that recession fears have faded. After all, the data has inflected markedly from the late-summer swoon, even as business spending and CEO confidence continue to urge caution.

Consumer sentiment, which plunged to a Trump-era nadir in August, has bounced back in true “V-shaped” fashion, and IHS Markit’s PMIs suggest ISM manufacturing is an outlier that can be safely dismissed.

Meanwhile, the labor market (which we’ll get a fresh read on later this week) has held up nicely, much to the delight of the White House.

Again, ISM manufacturing looks like an outlier.

Amid what might fairly be deemed rampant optimism (and remember, “rampant” just describes the ubiquity of the good vibes, not their intensity – nobody is projecting a blockbuster year for US growth), there are some holdouts and naysayers.

We’ve spilled gallons of digital ink discussing relatively downbeat views from SocGen and BNP, and this week, Rabobank’s call for the Fed to cut rates to zero in 2020 was back in the news courtesy of a Bloomberg TV interview with the bank’s Philip Marey.

It’s worth noting that this call is not “new”, per se. Some on “finance Twitter” this week appeared to suggest that this hasn’t been the bank’s base case previously – perhaps the most amusing thing about those tweets is that in at least one case, they emanated from outlets which covered the same call last year.

By way of background, Marey in August wrote that “after a pause in early 2020, we expect the Fed to respond to the rapidly deteriorating economic outlook by a rate cut of 25 bps in April”, on the way to a series of additional cuts. “By the June meeting of the FOMC it should be clear that a recession is imminent”, he went on to say, adding the following:

This should bring the FOMC out of its mid-cycle delusion and make another rate cut of 25 bps. As it is unlikely that the Fed will be able to avert a recession we expect a 25 bps cut at each following meeting, until the zero bound is reached in December 2020. In hindsight, a full-blown cutting cycle (6 consecutive cuts of 25 bps each) from April through December will bring the federal funds rate back to zero before the end of 2020.

Marey is hardly the only analyst inclined to describe the Fed’s “mid-cycle adjustment” narrative as a “delusion”, and Rabobank isn’t the only shop to adopt a shallow US recession as their base case in the new year (as alluded to above, SocGen also sees a mild US downturn in Q2 and Q3).

During the interview with Bloomberg’s Jonathan Ferro on Tuesday, Marey says that “if you just abstain from the current political events… you basically see all the classic signs that you see before a recession hits”.

He then zooms in on the re-steepening of the curve following inversion. “We saw a yield curve inversion last year, then we saw an un-inversion, and the Fed thinks this is a sign that it’s going better but in reality we have seen an un-inversion prior to the last three recessions”, he notes.

This is a fairly common warning. Indeed, over the past year, as various sections of the curve inverted, analysts were quick to suggest that folks should “fear the re-steepener”.

However, there is some nuance to this debate. The widening of the 2s10s back out beyond 30bps following the “crazy” (to quote the president) August inversion has come courtesy of the long-end. Asked by Ferro about the character of the inversion (i.e., bear steepeners versus the typical bull steepening into a downturn), Marey said “attributing everything to the long-end of the curve is a bit too simple of a story”.

Pressed by Ferro about the fact that the short-rate really hasn’t moved since August (see the top pane) while the long-end has, Marey went on to say that history suggests “it really doesn’t matter where the steepness comes from”.

He then noted the “weakness in the manufacturing sector” and the potential for that to eventually feed through to services. Here’s the short clip (and desktop users will forgive the small size – Bloomberg TV’s embed tools are somewhat lacking):

In August, when things appeared to be on the verge of falling apart amid spiraling trade tensions, Marey defended his prediction of the Fed moving back to the ZLB by noting that while the decline “may seem steep, we should keep in mind that you cannot fight a recession with only one or two rate cuts”.

In the same vein, Pimco’s Joachim Fels and Andrew Balls said this week that the US is set to lag an expected pickup in global growth early this year.

“Just as the US cycle lagged behind the global cycle during 2018 and 2019 with the US economy slowing later and by less than the rest of the world, we expect global growth to trough out and rebound earlier than US growth this year”, they wrote.

Real GDP growth will be between 1.5% and 2% in 2020, they went on project, cautioning that most of that growth will come in the second half. Below, for those who need a refresher, is the distribution of forecasts.

Despite Pimco’s somewhat subdued take on growth stateside, they recommend inflation hedges as central banks will “prefer the devil they know”, where that means policymakers will do what they can to avert a deflationary spiral, even if that means engineering an overshoot of inflation targets.

In November, Rabobank called 1% on US 10-year yields a likely “resting point” for year-end 2020. “We would judge the risks to this forecast to be tilted to the downside”, the bank said, adding that the factors weighing on yields are structural.

“It should come as little surprise that our outlook for rates is not so much lower for longer as lower forever”, a November 29 note reads.


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