Wall Street seems confident that the Federal Reserve will deliver a rate cut as its next policy move. With inflation remaining muted and growth concerns staying elevated due to global trade uncertainty, almost 80% of economists are expecting a rate cut before the end of summer, up from roughly 50% in May.
The Fed is in the middle of correcting a couple of policy and communication mistakes, and the markets should not be caught off guard if the central bank decides to deliver a surprise rate cut at June 18-19 meeting. While the Fed is historically slow to act, it has laid out the groundwork to officially signal a shift from a tightening bias to an easing one.
The Fed's preferred inflation measure is running well below its 2% target, and expectations have grown for price pressures to remain muted for the rest of the year. The Fed's minutes from the last policy meeting highlighted the downshift with inflation as transitory, reflecting temporary price declines.
U.S. inflation readings in May have shown weakness across the board. The headline reading – which shows what Americans pay for household services and goods – climbed 1.8% from a year ago, despite the strongest labor market that most Americans have ever enjoyed.
Federal Reserve Board Vice Chair Richard Clarida's favorite inflation indicator compiles the five- to ten-year inflation outlook, and that reading remains soft at 2.6%, still near the 2.3% record low. Muted inflation and the uncertainty from the lengthy trade war between China and the U.S. have been the primary drivers of increasing bets that the Fed will cut rates before the end of summer.
Treasury breakevens are very low and near historical levels that supported past actions from the Fed. Breakeven rates represent the average expected Consumer Price Index (CPI) inflation over the life of securities, and if those remain below the Fed's target, the Fed could argue that it has no reason to hold out on delivering a rate cut.
Right now, the markets are keenly focused on any incremental update related to global trade wars, but it is unlikely that we will get a meaningful update until the G20 summit in Japan at the end of the month. President Trump and his Chinese counterpart are expected to meet on the sidelines, and optimism is growing that both sides will try to move forward again in securing a trade deal. The risk is that we could see a further escalation in tariffs or a complete falling out between the world leaders, which could deliver a crippling blow for U.S. growth, thus supporting the argument for the Fed to be ready.
The futures markets are showing that at the June 18-19 Federal Open Market Committee (FOMC) meeting has a 27.6% chance of a 25-basis-point rate cut, while the July 31 meeting has an 87.0% expectation. The Fed has kept rates steady since the policy mistake of raising the target range to 2.25% to 2.50% at the Dec. 19 meeting.
U.S. equities have been fairly resilient in the face of an intensifying trade war and should see some support as the U.S. enters the tail end of what will be the longest economic cycle on record. As long as we don't see a catastrophic outcome in trade, U.S. stocks should remain well supported. Historically, we see strength in equities after the deliverance of the first rate cut in the beginning of an easing cycle, and that could be the catalyst to make another attempt for fresh record highs.
The U.S. dollar should be an interesting trade, as slower global growth will likely see strong demand for U.S. Treasuries. The dollar could be poised to weaken at the beginning of the easing cycle, but sustained declines may not be how price action unfolds.
The Bottom Line
If we do see a surprise cut at the Fed's June meeting next week, U.S. stocks could soar, and the initial wave of dollar weakness should support the European currencies. The futures market would also start to price in more rate cuts to occur before year end.
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