Fed at an inflection point
The US Markit PMIs released last week were weaker than expected. It is not a big surprise that the manufacturing sector is being hit by the manufacturing downturn globally, but we were caught by surprise by the sharp decline in the PMI service index as well . According to the PMIs, US GDP growth is currently just around 1% annualised, which is below trend, see chart to the right. Some of it may be due to transportation, which is dependent on manufacturing activity, but otherwise we are left a bit puzzled, as other indicators such as consumer confidence continue to show strength (see table page two).
Our base case for the Fed remaining on hold was that the real economy was in good shape but uncertainty has risen on the back of the weak PMIs . While the drop in Markit PMI service may just be a blip, it is one of the fastest released indicators and it will take time before we can get confirmation from other indicators.
The Fed has also changed reaction function by emphasising inflation expectations more . US 10Y breakeven inflation rates have declined during the risk-off and are not far away from the levels at which the Fed u-turned in early Q1 by ending the hiking cycle. It does not seem the Fed has to worry about inflation spinning out of control if it decides to ease monetary policy at this stage, despite the expansion being the longest on record. From a risk management perspective, the case for easing strengthens by the day.
The Fed is unlikely to cut rates in June but we expect the Fed to change its current neutral signal (‘no strong case for moving in either direction’) to a more dovish stance highlighting risks. Fed chair Powell could make this move during the press conference and in the FOMC statement at the next meeting on 18-19 June, but yesterday Fed vice chair Clarida opened the door for a rate cut if the outlook deteriorates. Clarida also mentioned that inflation expectations are “at the low end of a range” consistent with the 2% target. If we are right about the Fed making a dovish shift in rhetoric, we believe the Fed will make a 25bp insurance cut in July or September. While it is probably too early for the Fed to make more than an insurance cut at this point, the history from previous recessions is that the Fed can quickly make a more forceful response by cutting rates to 0% again.
As we wrote in FX Strategy: Policy inaction keeping a lid on EUR/USD , 21 May, an important prerequisite for a move in EUR/USD towards our 6M and 12M forecasts of 1.15 and 1.17 is a break with recent policy inaction . That could come from the Fed if it starts to turn more dovish. Rate cuts are not necessarily required. Hints about what it would take for the dovish market pricing of three cuts before end 2020 would be sufficient in our view for the market to start reversing its short position in EUR/USD. Until that happens the market is likely to continue to pick up the carry in short EUR/USD though.
Even though the market is already pricing a rate cut, a change in the policy stance should make US treasuries rally further depending on the reaction in risk markets. Some of the latest flattening of the 2s10s curve should be reversed.