Danger lurks beneath the consensus on Fed's next rate move

Federal Reserve Chairman Jerome Powell. Photo / AP

COMMENT:

At a time of immense political discord, it is heartening to see every analyst, trader, investor and economist under the firmament agreeing on at least one thing: the Federal Reserve is going to cut rates at the end of the month. But dangers lurk beneath this unanimity.

Even this weekend's apparent truce in the Sino-US trade war did little to dent expectations that the Fed is set to slash interest rates by a whole percentage point over the coming year. That has crimped the 10-year Treasury yield back to a fraction above 2 per cent, while slashing the yield on two-year Treasury notes.

But the most dramatic manifestation of the shift can be seen in the "eurodollar" market, which represents US dollars deposited in overseas accounts. Eurodollar futures are a popular way for traders to bet on US interest rates.

A year ago they were net "short" eurodollar futures — in other words, betting on interest rates rising — by about 3 million contracts. Today they are net "long" by 1.27 million contracts, which is the biggest wager on US interest rates being trimmed since early 2008.

The swing, meanwhile, is the most violent since at least 1993, when the Commodity Futures Trading Commission began collecting the data.

This looks wildly overdone.

Yes, the Fed is boxed in and will almost certainly cut interest rates this month. The G20 meeting led only to an uneasy, temporary trade de-escalation that will do little to help the global economy regain its vim. US jobs growth is expected to bounce back from May's miserable numbers, but even a blockbuster reading is unlikely to shift the minds of cautious Fed officials worried about their inability to get inflation up to their target.

Most of all, the consensus that the central bank will lower rates on July 31 means that refraining from doing so could cause carnage in financial markets. Even the more hawkish central bankers will blanch at that, making a precautionary "insurance cut" the path of least resistance.

Nonetheless, the market is probably overestimating just how aggressive the US central bank will be. Setting aside poor manufacturing activity surveys, the core economic data are far from alarming. The New York and Atlanta Feds' models indicate that growth is tracking at a tepid but hardly cataclysmic 1.5 per cent or so.

Unless data deteriorate sharply, it will be hard for markets to bully the Fed into unravelling all its 2018 rate increases so quickly. Maybe the bond market is right to think a severe slowdown — even a recession — is looming.

But former chairman Ben Bernanke was right when he warned that central banks responding to market pressures "quickly degenerates into a hall of mirrors" where both parties end up chasing each other around.

It might therefore make more sense to sell short-term US Treasuries and eurodollar futures that are priced for an unrealistically grim scenario.

Written by: Robin Wigglesworth

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