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Fed officials are expected to deliver their first interest rate cut since December 2008. Despite the fact that the economic conditions do
not justify looser monetary policy, Jerome Powell should trim the Fed funds rate target band by 25bps to 2%-2.25%. According to Fed
Funds futures, the market is now pricing a 50bps cut with 20% probability, while there is 80% chance that the Fed cut by only 25bps. We
believe the latter is much more likely as a 50bps cut will severely limit the Fed’s room to maneuver in case of an acute economic downturn.
Indeed, in case an economic recession effectively strikes, the Fed will find itself in a difficult situation, as it has only been able to
lift interest rate back to 2.25% - compared to 5.25% before the global financial crisis- and to reduce its balance sheet to USD 3.85tn –
compared to USD 0.87tn pre-GFC. Therefore, Chairman Powell should take it slowly and not waste all its ammunitions at once. On Monday,
Donald Trump has been calling for a “large cut” in interest rate as it would prop up the stock market and weaken the dollar.
We are not convinced that the Fed would go beyond a 25bps cut, as it would make its job more complicated in the coming months. Recently, the dollar has greatly benefited from heightened uncertainties about the outlook for the global economy, thanks to its ultimate “safe-haven” status. However, FX traders seem to have discounted the potential effects of lower interest rate on the greenback or maybe they are less convinced that the Fed would cut aggressively. Looking at the valuation of the equity market, investors are waiting resolutely for a dovish outcome and we anticipate they are going to be disappointed.
By
Arnaud Masset
