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Morningstar | Fed Maintains Policy Rate, but Rate Cut Drama Is Increasing

This was perhaps the first Federal Open Market Committee (FOMC) meeting of the year that carried with it an element of uncertainty. With the futures market pricing in an ever-increasing chance of multiple cuts in 2019, there were serious questions about whether the Fed would stick to the same script as it has before--no cuts, staying patient, and we are currently at neutral--or whether it would signal a rate cut for its next meeting in July (which the futures market had already priced in ahead of the meeting) or potentially cut rates during this month's meeting.

Previously, it had been a relative certitude that no rate cuts were on the table, nor was there the same level of anticipation around the potential for future cuts. With the conclusion of its June meeting, the FOMC voted to maintain its target rate range at 2.25%-2.50% and also signaled that rate cuts could be coming in the very near future. For the first time under Jerome Powell's tenure, the vote for keeping rates stable was not unanimous, as James Bullard voted to lower the target range by 25 basis points. This overall sentiment was mirrored in the dot plot, which became much more dovish--signaling that rate cuts could very well be around the corner.

The economic picture remains mixed, with some positives and some negatives, and arguments abounding for why it could shift in either direction. Some leading indicators have been pointing to GDP growth slowing down from the unusually strong 3.1% print we saw during the first quarter. Inflation, depending on which indicator you look at, is either muted, stable, or up (with some of the latter conclusions derived from alternative indicators like mean and median CPI). The language in the Fed's current release again highlighted the continually soft business fixed investment and increasing uncertainties around the future outlook. The Fed also dropped its language around remaining "patient"and now states that the committee will "act as appropriate to sustain the expansion," which we view as more dovish in the face of a number of geopolitical risks, such as trade wars and Brexit along with potentially slowing GDP and job growth. While the Fed has now opened up the door for one to several rate cuts going forward, the key questions in our mind are how low do we go--back to zero? And how long do we stay low--seven years like last time or does the trough last for only a couple years (as it often had prior to the 2008-09 financial crisis)?

The current meeting featured a new dot plot release and new economic projections. Interestingly enough, the economic projections became more bullish, with the change in real GDP improving slightly in 2020 as well as a better unemployment rate in both 2020 and 2021. This may be in reaction to the rate cuts they expect to occur, which could be expected to boost the economy, as the median fed funds rate in 2020 is now expected to be 2.1%, down from the 2.6% figure in the March release. The dot plot now has eight members seeing rate cuts in 2019, with seven of those members seeing two cuts occurring. We may begin to re-evaluate our short-term rate outlook for the banks--which currently assumes no rate movements in 2019 and a single hike in mid-2020--as rate cuts, while possibly the right move for the U.S. economy, will lead to net interest margin compression, hurting the bottom line of the banks. If NIMs are only slightly compressed for a couple years due to one to three rate cuts, this would not cause significant drops in our fair value estimates among our banking coverage, although there would be minor declines. CME futures data has shifted a bit since the last meeting, which occurred in May. The futures data now points to two to three rate cuts occurring in 2019. Bigger drops in our fair value estimates for the banks would come from rates dropping to zero for a sustained period of time.