The last week of October is going to be an important one for the global financial markets. As Europe and Japan have trillions of dollars worth of negative yields on their sovereign debt, U.S. Treasury yields remain much higher on a relative basis. The United States has been the one beacon in the global storm of slower economic growth, and that is despite all the political wranglings in Washington, D.C., and the fears of what may occur if the trade war is not resolved. The conundrum here in the United States is that interest rates are quite low by historical U.S. standards, even if they are much higher than what is available elsewhere.
The importance for the week of October 31 is that the Federal Reserve’s Federal Open Market Committee (FOMC) is expected to reveal another federal funds rate cut. Its current range for fed funds is 1.75% to 2.00% and the rate cut, and if it comes as expected, would take that rate down to a range of 1.50% to 1.75%.
According to the CME FedWatch Tool, there was a 94.1% probability that Fed Chair Jerome Powell and his voting FOMC members will lower the fed funds target rate by the traditional 0.25%. One reason this FOMC meeting outcome is so important is because there is not another formal FOMC meeting scheduled until December. That would mean that if the FOMC decides not to cut rates then there would not be another chance for an interest rate cut until December 11, 2019. If there are any more global or U.S. economic scares, that’s a long time for the Fed to have its hands tied.
Powell and the voting FOMC members actually could cut rates at any time without a formal FOMC meeting on the schedule, but surprise rate cuts in between FOMC meetings usually happen during a period of significant negative surprises. It’s also possible that the market might take a surprise move as “What does the Fed know now that we don’t know?” and that could send the equity markets and long-term bond yields lower.
Earnings have so far not been as cautious as the street had been prepared for, and there are literally too many issues happening in Washington, D.C., to easily count. One that is easy to look at is the shape of the U.S. Treasury yield curve. In normal markets, short-term interest rates are lower than long-term interest rates. When that is not the case, the yield curve is either flat or, worse, it can be an inverted yield curve, which has been a predictor of so many recessions in the past.
For much of 2019, the U.S. Treasury yield curve has been flat or slightly inverted. The market’s view was that Powell and the FOMC were behind the curve more than there was an imminent recession hitting us. Over the past month, short-term rates have come down by about 12 to 15 basis points on maturities under a year while interest rates have generally risen by about 12 to 20 basis in maturities of five years to 30 years.
After having hit 1.50%, the yield on the 10-year Treasury note has now come back up to 1.85% as the yield curve has started to normalize, and the yield on the 30-year long bond was barely 2.00% in the past 60 days, but now that is back up to 2.34%. The reality is that the financial markets need and want to see higher U.S. interest rates for long-term notes and bonds because it is a sign of confidence and that the economy is not on the brink of very bad news again.
Again, the CME FedWatch Tool shows a 94.1% probability that Powell and the FOMC will take another 25 basis point cut on Wednesday, October 30. That said, the FedWatch Tool’s current probability of rates staying pat after this week’s would-be rate-cut is 77.8% (and only 17.4% for another 25 basis point cut) for the December 11 FOMC meeting.
To complicate matters further, the S&P 500 has now traded above 3,040 on Monday for an all-time high. Perhaps this could have been titled “The Fed Better Hurry and Cut Rates While It Still Can” or something to that effect.