JULY FOMC MEETING – CUT N’ FLY
Backdrop
The US Federal Reserve has cut interest rates by 25bps for the first time in almost ten years. It cited consistently undershooting inflation and increasing headwinds to economic growth as the main triggers to this change in monetary policy. In addition, the Fed decided to terminate its balance sheet runoff on August 1st, two months earlier than initially planned in an effort to stop shrinking the US monetary base and ease financing conditions.
In terms of forward guidance, the door is left open for more easing should economic conditions require it. In the press conference, Fed Chairman Jerome Powell explained the sequence that led to the policy change, and reinforced the pre-emptive nature of the measure as a “mid-cycle adjustment” to the policy.
The statement contained few surprises: the Fed is paying to see what is in the cards and provide support at a stage in the cycle where inflation is plummeting and growth is slowing. In any case, the FOMC’s stance is nowhere near being more dovish than expected, and remains data dependent to assess what the next move ought to be.
Market Impact
Expectations were very high going into the meeting and many participants anticipated a more aggressive stance with two cuts and dovish guidance.
Asset Allocation Consequences
What went around, came around. After a period of patience and economic assessment earlier in the year, the Fed is now taking action. The decision is probably the first step in a sequence of adjustments in monetary policy, aimed at reviving economic expansion and bringing inflation closer to the bank’s 2% target.
With this in mind, our current dynamic assessment articulates around three risk factors:
- Macro Risk: Growth conditions as indicated by our proprietary Nowcasters, have stabilised around potential and show only minimal signs of improvement. The latest GDP print in the US is reassuring but remains the exception in the developed world. On the other hand, disinflation is still at work and remains the main source of concern for central bankers. This in turn will warrant larger accommodation for longer from central banks, until fundamentals materially firm. In the medium run, this dimension will remain supportive and benefit growth-oriented assets such as equities and credit.
- Market Sentiment: Risk appetite remained solid through July, and should remain so now that the Fed has provided clarity on its future course of action. It would require a shock to reverse current optimism, such as a rapid surge in trade war tensions or a poor earnings season, for example. In the absence of a trigger, momentum should persist as positioning does not seem extreme yet and leaves room for another leg of positive returns. The picture is less clear on this front though, as expectations and market pricing were high going into the FOMC meeting.
- Valuation: Most assets have become rich as a result of central bank action. Currently, hedging assets are more expensive than risky assets, which could trigger correlation distortions and limit their defensiveness. This favours relative value plays over long beta exposures.
As central bank support is here to stay for at least until the end of the year, the macro environment remains benign enough to warrant accommodation while market sentiment is mixed and valuation less favourable. Therefore, we currently favour carry strategies (in credit and FX) and tactically hedging risk asset exposure through convex optional positions on equity indices.
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