Central Banks Prepare for a Global Economic Slowdown
Last week the Fed left the overnight rate unchanged but, as expected, downgraded its assessment of the economy while dropping language referring to its intention to be “patient” regarding interest rate policy. Expectations are high that a rate cut could happen as early as July when the Fed meets on the 30th and 31st. The CME Fedwatch Tool now ascribes a 100 percent chance that rates will be lowered in July, the only question being whether the cut will be one-quarter percent or one-half, to which the tool ascribes a 28 percent chance. St. Louis Fed president Bullard abstained from voting to leave policy unchanged, preferring an immediate quarter-point cut.
Global markets also received a boost earlier in the week when European Central Bank president Draghi reiterated his view that the bank is prepared to use all available tools at its disposal to support growth and reach its inflation target.
To what extent central banks ultimately ease policy, and how effective it might be, remains to be seen. Much depends on the path forward in the U.S.-China trade war. No major breakthrough is expected this week, but there is a chance that the meeting might still be viewed as constructive if negotiations are re-engaged and new tariffs are put on hold. Such an outcome could lend additional support to the current rebound in stock prices, and likely push bond yields somewhat higher. Of course, the opposite is also true, leaving much riding on the outcome.
Bond Yields and the Dollar Fell on the Fed’s Decision
Bond yields fell in the wake of the Fed’s decision. After trading as high as 2.08 percent before the Fed’s decision, the yield on the ten-year note dipped as low as 1.97 percent on Thursday, its lowest since November 2016 before rebounding to end the week at 2.05 percent. And after trading at 1.90 percent prior to the Fed’s announcement, the two-year note fell to 1.70 percent on Thursday, its lowest level since November 2017, before climbing back to end the week at 1.77 percent. Below-investment grade bond yields extended their descent, which began on June 4 when Fed Chair first said that the Fed will, “act as appropriate to sustain the expansion,” the same language contained in the post-meeting statement. On June 3 the yield on the Bank of America Merrill Lynch High Yield index was 6.96 and its spread over Treasuries was 470 basis points. By Friday, the yield had dropped to 6.41 and the spread had contracted to 395 basis points.
The dollar also fell in response to the Fed. After closing at 97.64 on Tuesday, the DXY dollar index fell for three straight days to end the week at 96.22, erasing all but a fraction of its gain from the start of the year. Emerging market equities responded favorably as the MSCI Emerging Market index climbed 3.8 percent for the week. Over the same final three days of the week gold climbed $53 to $1400 an ounce, its highest price in almost six years. And the price of oil spiked in response to rising tensions between the U.S. and Iran.
The Fed Will be Closely Watching the G-20 Meeting this Week
The global economy is slowing, and central banks are preparing to respond. Most of the slowdown is contained in the manufacturing sector, where such activity in the U.S. slowed again in May to just above the expansion/contraction divide. But in the U.S., consumers and small businesses remain healthy and optimistic. This leaves the Fed in a delicate position. Just as investors are watching closely the G-20 meeting this week, so too is the Fed. With an economy likely growing somewhere near 2 percent, and unemployment at a five decade low, how much additional monetary accommodation is needed is unclear. If the outlook improves following the G-20 meeting, the answer may be less than the market is currently assuming. On the other hand, if little progress is made in Osaka, and manufacturing and trade remain under pressure, along with business sentiment, the burden will only increase on the Fed and its international counterparts to do the heavy lifting.
There is also the issue of inflation, which remains stubbornly below the targets of the major central banks, including the Fed. The PCE deflator for May is scheduled for release on Friday, and the core rate is expected to hold steady at 1.6 percent year-over-year, below the target of 2 percent, another reason for the Fed to want to lower rates. Given these uncertainties, the Fed was wise to wait and see what transpires this week, allowing for a more informed decision in July.
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Past performance is not a guarantee of future results.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The CME FedWatch Tool analyzes the probability of FOMC rate moves for upcoming meetings. Using 30-Day Fed Fund futures pricing data, which have long been relied upon to express the market’s views on the likelihood of changes in U.S. monetary policy, the tool visualizes both current and historical probabilities of various FOMC rate change outcomes for a given meeting date. The tool also shows the Fed’s “Dot Plot,” which reflects FOMC members’ expectations for the Fed target rate over time.
The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis (BEA).
Indexes are unmanaged and are not available for direct investment.
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