Global Factors Impacting the Fed's Rate Policy
July 11, 2019
My sense is that Jerome Powell, Chairman of the U.S. Federal Reserve, is more concerned about global financial conditions, namely weak global PMIs, low global inflation, and weakening growth everywhere, than he is pacified by a strong U.S. labor market. The Fed detailed the idea of incorporating global factors into their policy reaction function in a June 2019 paper entitled: Monetary Policy & Financial Conditions: A Cross Country Study.1 Here they introduce an ‘augmented’ Taylor Rule2 that adds the notion of GDP-at-Risk by incorporating financial conditions alongside the already familiar inflation and full employment variables. I see this as an important development; this deserves more attention than the market is currently paying towards it because it explains the Fed’s policy reaction function today.
The market is currently pricing a 25 basis point (bps) interest rate cut by the Fed in July. However, I think a higher probability should be assigned to a 50 bps rate cut.
The Fed’s thinking may be as follows: they need to cut rates by at least 50 bps this year, so why wait? They can cut rates by 50 bps in July and then still have the flexibility to cut another 25 bps later in the year if needed.
Furthermore, if the Fed is thinking along the lines of risk management, they may be more inclined toward a 50 bps cut. If there is in fact evidence of a more substantial weakening of U.S. and global growth, then a 25 bps cut is less effective versus a 50 bps cut, as the later would give the Fed extra “insurance” against a declining market. The Fed could then opt not to cut further if economic activity picks up.
I realize my view goes against the market consensus, but in order to better understand the Fed’s reaction function we need to appreciate that it is increasingly evaluating financial conditions both in the U.S. and around the globe.
If you evaluate their actions through that lens, then a 50 bps cut doesn’t seem so unreasonable, or unlikely; perhaps Chairman Powell wants to keep this (“put”) option open. In conclusion, Powell may not push back on a 50 bps rate cut as much as the market was thinking.
A Note on Emerging Markets
We believe that emerging market (EM) fixed income may have the most upside surprise potential for the second half of 2019.
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities ("junk bonds") are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.