Expectation of Fed rate cut seems an over-reaction, so reality may be different

Herd instinct is the human nature to follow the crowd and act collectively - and market expectation always does not change smoothly but tends to over-react to new information. The current market expectation of the US Federal Reserve's rate cuts is a case in point.

On June 20, the latest meeting of the Fed's policy-setting Federal Open Market Committee shrugged off the market's high expectation of rate cuts and gave no clear policy signal confirming a cut.

We believe the market had overreacted in forming its expectation of rate cuts after the Fed swiftly adopted a dovish tone from the end of last year. Specifically, we believe market expectation - it has formed since May - of a change in policy stance, as well as the timing and degree of rate cuts, may not fully materialize.

We will elaborate on this now. It should be noted the misconceived expectation of Fed rate cuts could induce a drastic reversal in investor sentiment and asset price fluctuations, if the Fed's moves miss expectation.

Firstly, the market may have overestimated the degree of the Fed's policy stance change. A clear rate cut signal may not emerge until the end of this month.

According to Bloomberg, the Fed funds futures market has recently priced in a 98.5-percent chance that the Fed will lower rates at least once this year.

However, the Fed's earlier forward guidance only indicated the end of monetary policy normalization, which does not necessarily point to the beginning of a rate cut cycle. Also, the Fed has removed the word "patient" from the latest FOMC meeting statement but did not confirm a rate-cut stance.

We believe that because of the following two reasons, the Fed is still on cautious lookout, and there will not be any clear rate cut signal or plan until the next FOMC meeting at the end of this month.

Externally, the Fed is expected to stand pat until trade dispute uncertainties ease, to give itself an advantage in its game with the US Administration.

The Fed would put itself in an unfavorable position if it initiated a rate cut before major uncertainties over the China-US trade dispute are removed, because the pre-emptive move may encourage the US Administration to escalate the trade dispute, which will in turn pose a dilemma to the Fed.

That's because any escalation in trade tensions will, on the one hand, dissipate and even offset the easing boost from rate cuts and force the Fed to accelerate the rate cut pace. On the other hand, the escalation could further fuel imported inflation, which will significantly reduce the Fed's room for rate cuts. The Fed will then face a policy-making dilemma of whether to further cut rates.

To avoid this dilemma, the best option for the Fed is to consider the timing and degree of rate cuts after trade friction uncertainties are eased after the G20 summit, which ended last week.

Internally, US economic data that will be released in the middle of this month may cement the Fed's determination to cut rates.

Since 2011, whenever the actual US GDP growth rate exceeded the endogenous growth rate by more than 1.5 percent, the actual figure underperformed the theoretical figure in the next quarter. That's because a significant departure from endogenous growth can hardly sustain.

In the first quarter of this year, the actual growth rate outpaced the theoretical rate by 2.09 percent, the highest level since the fourth quarter of 2011. If the historical pattern still works, this strong economic data could mean a sharp plunge in the second quarter.

As the Fed said it will closely monitor the implications of incoming information for the economic outlook, disappointing economic data to be released later this month may become the last straw for the Fed to act. Therefore, a clear rate cut sign and path may emerge at the FOMC meeting at the end of this month after the Fed digests the data.

Secondly, the market may have forecast the timing of rate cuts earlier than the Fed's actual plan. The rate cut window is expected to open as late as in the fourth quarter.

Before the latest FOMC meeting, traders saw a more than 70-percent chance that the first rate cut will take place this month, as well as a 96-percent chance that at least one rate cut will take place by the end of September.

However, this estimation may excessively go ahead of the Fed's actual moves. We expect that the rate cut window will open in the fourth quarter, with the first cut likely to come in December or January.

Looking back in history, the average time the Fed took to switch their rate policy - or the time interval between last rate hike and first rate cut and vice versa - has been 11.7 months since 2000, even excluding the post-2008 prolonged low-rate period. Based on this pattern, the rate cut is unlikely to come this month but more likely to come after September.

Besides the historical pattern that probably continues, two new factors will also delay the timing of the first rate cut.

On the one hand, the current US policy rate is the lowest among those in all the periods when the Fed planned to start a round of rate cuts, indicating the limited room for rate cut. This makes it necessary to use the limited rate cut capacity at an appropriate timing, which may occur later than the market expects as the US growth pressure will not peak this year but in 2020, according to IMF estimates.

On the other hand, unlike in the past, the Fed now has to take the delayed effect of balance sheet reduction conducted earlier into its consideration of rate cuts. The current phase-out of balance sheet reduction already has some easing effect, and only after the balance sheet reduction ends in September, can its impact become clearer.

By incorporating that impact into consideration, the Fed can draw up a better rate cut plan that maximizes effects of the policy mix.

Thirdly, the market may have overestimated how much the Fed will cut the rates. There may be no more than three rate cuts by the end of 2020.

St. Louis Fed President James Bullard - the major advocate of this round of rate cut - has suggested the use of the modern-day Taylor rule, which fairly well explains the Fed's interest rate decisions. Even based on this model adopted by dovish Fed officials, we found that the degree of rate cuts may be weaker than market expectation for quite some time going forward: at most one cut by the end of this year and likely two or three cuts by the end of 2020.

By contrast, before the June FOMC meeting, the market expected a higher-than-85-percent chance of more than one rate cut by the end of this year as well as an about 60-percent chance of more than three cuts by the end of 2020, according to Bloomberg data.

In conclusion, we think as economic downside pressure gradually emerges, the Fed will have to kick off the rate cut cycle. But the rate cut signal, timing and degree may not measure up to the market expectation. Therefore, two future developments appear possible:

First, investor sentiment can reverse drastically if the Fed's action fails to meet market expectation. Considering the market has fully priced in the unrealistic expectation of rate cuts since early June, any reversal of expectation can lead to short-term fluctuations of key price signals such as the US Treasury yield curve, the US Dollar Index, and the gold price, which may pose extensive spillover shocks to asset portfolios.

Second, the long-term trend of rate cuts will continue even if the market expectation reverses. In the long run, the Fed is expected to proceed with rate cuts in a fairly slow and smooth way. This will enlarge the monetary policy room of other major economies and expedite the shift toward an easing global monetary environment, which may in turn lift the sentiment of global stock markets and ease any currency risk of emerging markets gradually.

Cheng Shi is the managing director, head of research and chief economist of ICBC International Holdings Ltd.

Qian Zhijun is a senior economist of ICBC International Holdings Ltd.

(China Daily Global 07/01/2019 page9)