The Daily Update - A Busy Week at the Fed

We expect the Fed to cut rates this evening by another 25bps while retaining its core guidance language, describing the reduction as a mid-cycle adjustment, while keeping to: ‘we will take action as appropriate to sustain the expansion’. The futures market is already pricing in not only today’s expected move but a further 25bps before January next year.

The ‘dot plot’ of Fed member future expectations of the fund's rate could be the cause of a surprise, although the actual level of future rates has always been shown as too high we do expect a drop in the members’ future outlook. This is not really to do with shorter-term worries such as trade wars or even Brexit pressure but more to do with the outlook for inflation, the flatness of the Philip’s curve, instances of the US curve’s inversion and the outlook for the so-called neutral rate not only in the US but also abroad. In this regard we look for the Fed to signal further rate cuts out past 2020 via the ‘dot plot’ while keeping to their mid-cycle adjustment communication, broadly, short-term still data-dependent but longer-term moving down the future neutral funds rate.

In the meantime, Federal Reserve traders jumped into the money markets to inject cash yesterday, the first time in a decade, as short-term rates spiked up as high as 10% as liquidity dried up. There appears to be a structural problem in the market with limited cash available to fund day-to-day activity. Record US Treasury issuance is taking money out of circulation at a time of lean Wall Street balance sheets and incidentally there was a draw on cash to pay companies quarterly tax bills.

Overnight rates settled back at 4% after the Fed intervention and we expect a further round today to help in the short term to get rates down further towards the funds rate. These operations in the repo market were common before the financial crisis but have since changed due to the expanding Fed balance sheet and target rate bands which have been used to manage liquidity; we may be seeing a return to active Fed trader intervention in the repo market.

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