The Fed cuts rate, but the market expects more

Temporary stress in the repo market

The market for repurchase agreements, or repos, came under stress during the week of September 16, as the combination of a quarterly corporate tax payment deadline and a large amount of Treasury new issue settlements resulted in a temporary mismatch in the demand for funding and the availability of cash. Overnight repo rates, which had been roughly 2.2%, rose as high as 10% as borrowers scrambled for short-term financing. In response to the short age of funding, the Federal Reserve Bank of NY injected $75 billion of cash into the market via temporary open market operations to help alleviate market stress. Repo rates quickly returned to the 2% range. While a sudden pullback in liquidity and its impact on the short term repo markets is not a new occurrence, the magnitude of this event was greater than recent episodes. This was in part due to the decline in the Fed’s balance sheet and excess reserves in the banking system. Given the recent tapering in the Fed’s balance sheet, domestic excess reserves have declined from $2.5 trillion in 2014 to approximately $1.5 trillion today. Research by economists at the Federal Reserve Banks of Philadelphia and New York estimates that under the FOMC’s current floor system for managing the effective Fed Funds rate, the required supply of reserves could range from $500 billion to $1.2 trillion, depending on the distribution of excess reserves across banks. The recent stress in the money markets suggests that the required supply of reserves is somewhat higher than $1.2 trillion, and it is likely the FOMC will resume trend growth of its balance sheet as early as November of this year.

US Rate Outlook

We view the Fed’s current easing as a mid-cycle adjustment as it works to “fine-tune” policy in the face of elevated global uncertainties, rather than an attempt to truncate a recessionary economic environment. Barring a deterioration in the outlook for US growth and the US labor market, and barring a further escalation in the US-China trade war, the Fed is likely to pause to monitor the effects of the rate cuts on the economy. The Fed dot plot indicates that the long-term neutral rate remains at 2.5%. This suggests the bias for rates is ultimately higher rather than lower. By most valuation metrics, US 10-year Treasuries are expensive, and external events have played a large role in the recent move lower in US yields. We expect the US Treasuries to move in a trading range in the short term, with limited upside in yields expected in the next six months. But we could see some upward pressure in yields should growth prove more resilient than expected.

Investment implications

Given our outlook and current market valuations, we view it appropriate for fixed income investors to seek opportunities across multiple sectors, move up in quality, and maintain a relatively modest risk stance. Taking positions in securitized credit sectors, such as asset-backed securities, commercial mortgage-backed securities and residential mortgage-backed securities, are consistent with this approach. These sectors are particularly attractive when considering valuations, strong credit protections, a US consumer focus, and lower exposure to global growth risks. Agency mortgage-backed securities are also increasingly attractive following the recent widening in spreads. On duration, we believe that interest rate duration exposure in US fixed income should be limited. The strength of the services sector, the consumer and small businesses support a view of higher US rates and a more reserved Fed. That said, we recognize the benefit of long duration US Treasuries as a hedge in a risk off environment.