Rate cuts “may be warranted soon”
Said James yesterday afternoon
The bond market soared
Though stocks ‘cross the board
Retreated the third day of June

Will someone please explain to me how the Fed expects to be preemptive on economic movements by looking in the rearview mirror? Given that data is almost always backwards looking, (only the ISM surveys really try to look ahead) it seems it would be a far better process to simply explain the reaction function will follow the economy. It is abundantly clear that they have completely lost the ability to lead the economy. So now, following a spate of softer data leading to comments from St Louis Fed President James Bullard about cutting rates soon, Treasury yields have plumbed new depths for the move, touching as low as 2.07% on Monday, and although they have rebounded slightly this morning, there is no indication this movement is going to stop. Weaker ISM data, slower housing growth and ongoing trade uncertainty have certainly stacked the deck against the Fed standing pat. Chairman Powell speaks this morning and markets will be anxiously awaiting his wisdom on the subject. (Spoiler alert, his only choice will be to sound dovish as any hawkish tone will immediately reflect in an equity sell-off.)

Similarly, we continue to see German bund yields pressing to new lows, -0.21% this morning, and the pressure on the ECB to respond is growing stronger. Just this weekend there was a story in Bloomberg describing Eurozone inflation as starting to trend higher. Alas, this morning’s data printed weaker than expected with headline CPI at 1.2% and core at 0.8%. While the euro has barely reacted, interest rate markets are starting to price in even more easing by the ECB and analyst’s comments are moving towards the need for Signor Draghi to do something to show that the ECB is in control. The problem for Draghi is he only has a few more months in the seat and all eyes are looking toward his potential replacement. While there is no strong consensus pick, the view is developing that whoever takes the role will be more hawkish than Draghi, by default. At least initially. However, if Eurozone growth continues to falter and inflation remains around 1.0%, instead of nearer its target of “close to but below 2.0%”, that hawkishness is likely to fade. And one last thing, Eurozone inflation expectations, as measured by five year forward five-year swaps have fallen to near record lows of 1.28%. In other words, nobody thinks inflation is making a comeback soon.

Adding to the interest rate gloom was Australia, last night, cutting its base rate to 1.25%, as widely expected. RBA Governor Lowe made it clear that given the slowing picture in China and the overall slowdown in global growth, the door is open for further rate cuts there. Markets are pricing in at least two more by the end of the year.

How about Switzerland? The nation with the world’s lowest interest rates, the cash rate is -0.75%, is being forecast to cut them further. Given the haven status of the Swiss franc and its recent appreciation vs. the euro, analysts are now looking for another rate cut there. So is the futures market, with a 50% probability of a 25bp cut priced in for March 2020., and SNB President Thomas Jordan has done nothing to dissuade these ideas. If anything, I would expect a cut before the end of the year.

My point is that despite the recent turn in US markets regarding interest rates, where virtually every analyst has come around to the idea that the next move in rates will be lower, and clearly there are Fed members in that camp, none of this happens in isolation. As the above discussion highlights, more dovish policy is quickly becoming the baseline forecast for virtually every country that matters.

So, what does that do for the dollar? Yesterday’s price action showed the dollar’s worst performance since mid-March, when Chairman Powell surprised the market with an uber-dovish policy statement and press conference. Bullard’s comments were enough to turn views toward a rate cut happening much sooner than previously anticipated. And so, if the Fed has truly turned around their thought process, then it will be no surprise for the dollar to have a weak period. Of course, this will only last until we hear Draghi talk about the room for further easing and the need to maintain price stability near the ECB’s target. Once it is clear that the ECB is also going to ease further, the dollar will likely find a bottom. Remember, the ECB meets tomorrow and Thursday, with Draghi’s press conference at 8:30 Thursday morning. Given the recent data, and the overall trade situation, it is not impossible that the ECB turns far more dovish this week. However, my sense is they will focus on the terms of the new TLTRO’s and not on restarting QE. So, the dollar probably has a few weeks of underperformance ahead of it, but it is only a matter of time before the ECB (and correspondingly the BOJ, BOE and BOC) jump on the dovish bandwagon.

As an aside, I keep reading that the only way for the Fed to create a dovish surprise later this month is to cut immediately (the market is pricing in a 25bp cut at the July meeting) but I disagree. All they have to do is cut by more than 25bps when they cut. There is no rule that says 25bps is the proper amount to move rates. If the consensus view is turning to a sharper slowdown, it would be better to get ahead of the problem than to be seen as offering policy prescriptions that are ‘too little, too late.’ It appears to me that President Trump will get his way regarding the Fed, with easier money to come sooner rather than later. Alas, I fear that the stock market may not respond in the manner desired. At this point, cutting rates speaks to panic at the Fed that things are much worse than they have been describing. If that is the perception, equity markets have only one way to go…down.

On the data front, yesterday saw the weakest ISM print since October 2016, which is completely in line with what we are seeing around the world, slowing manufacturing growth. This morning, the only hard data is Factory Orders (exp -0.9%) but both Powell and NY Fed President Williams speak. The default expectation for them both is turning more dovish, and if they live up to that billing, the dollar is likely to continue its recent decline. But, if somehow they sound hawkish, look for the dollar to reverse higher quickly. Remember, FX is still a relative game and its recent weakness is predicated on a more dovish Fed. Changing that changes the market’s perception.

Good luck