Can Anything Delay the Inevitable July Fed Rate Cut?

(Bloomberg Opinion) -- For weeks now, financial markets have been treating a July interest-rate cut by the Federal Reserve as a sure thing. That's a big deal because over the past quarter-century, the central bank has never failed to deliver when implied odds reach 100%.

I'm certainly not one to fight the bond markets. But … there's a first time for everything. What would it take to spur Chair Jerome Powell and other officials to defy traders and keep interest rates where they are? It's not a completely far-fetched question — a survey conducted this week by BMO Capital Markets showed respondents on average gave 20% odds that the central bank won't lower its benchmark rate on July 31.

How to get from here to there? The short answer: It would take a lot. The longer answer: It would take a string of strong data releases, no more unexpected trade threats out of the White House, and perhaps some help from abroad.

There's not much time for Fed officials to get the markets on board with a “no cut” scenario. Their decision is four weeks away, and the blackout period starts even sooner. That means this week's employment data take on added significance. Without a convincing rebound from last month, it seems highly unlikely that policy makers will push to keep interest rates steady. Labor market strength has been the core pillar of this tightening cycle, and another lackluster payrolls report would probably push those on the fence toward a July “insurance cut.”

Suppose, though, that payrolls increase by at least 164,000 (the median estimate in a Bloomberg survey); the 75,000 gain from May stays the same or is revised higher; the unemployment rate remains pinned at the lowest in five decades; and annual wage growth at least meets expectations of 3.2%. That's all within the realm of possibility. A payrolls estimate from ADP on Wednesday showed a gain of 102,000 jobs in June, a healthy rebound from last month's dismal 27,000. While lower than the expected 140,000, the report tends to have limited predictive power over the more crucial Labor Department data. In last year's June readings, ADP undershot by 36,000.

Those figures, combined with the U.S.-China trade truce coming out of the Group of 20 meeting, would alleviate some of the “uncertainty” that has bothered Fed officials. Consider these comments from Powell on June 25: “The question my colleagues and I are grappling with is whether these uncertainties will continue to weigh on the outlook and thus call for additional policy accommodation,” he said. “But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty.” 

If the Fed sees the resilient labor market as reason to potentially stand pat, a parade of policy makers will have a chance to jawbone the market next week. St. Louis Fed President James Bullard and Atlanta Fed President Raphael Bostic kick things off on July 9. Bullard, the lone dissenter in favor of lowering interest rates at the June meeting, last week effectively shifted traders away from expecting a sharp 50-basis-point reduction.

Powell will testify before the House Financial Services Panel on July 10 and before the Senate Banking Committee the next day. It's hardly the ideal environment to provide a clear message to markets — Democrats will likely ask about President Donald Trump's persistently critical comments, while Republicans may argue the Fed is holding back economic growth.

Notably, the Senate testimony will start after the release of minutes of the Fed's June meeting and the latest round of consumer price index data. A surprisingly strong read of inflation could encourage Powell to reiterate that the central bank is meeting its dual mandate and perhaps deviate from some of the views expressed last month. As if that weren't enough, on the same day, New York Fed President John Williams, Bostic, Richmond Fed President Thomas Barkin and Minneapolis Fed President Neel Kashkari are all scheduled to speak.

Fed speakers have coordinated to sway the markets before. Less than three weeks before the central bank raised interest rates in March 2017, traders were pricing in about a one-in-three chance of that happening. The following day, some forceful comments from Williams, the president of the San Francisco Fed at the time, and William Dudley, the New York Fed president at the time, sent those odds above 70%. Within a week, the probability of a hike was 96% and just one of the Fed's 23 primary dealers was calling for no hike.

Simply put, market expectations can change in a hurry. And at least some non-voting Fed members seem to be thinking that July feels a bit rushed. Barkin, in a Wall Street Journal interview conducted June 28, said it's too soon to say whether global economic weakness could prompt a rate cut. Cleveland Fed President Loretta Mester on Tuesday laid out the clearest case yet for not lowering interest rates. What would change her mind? “If I see a few weak job reports, further declines in manufacturing activity, indicators pointing to weaker business investment and consumption, and declines in readings of longer-term inflation expectations, I would view this as evidence that the base case is shifting to the weak-growth scenario,” she said.

That's quite the list. It's possible that Mester is simply more hawkish than her colleagues who vote on policy this year and that the doves will win out.

On the other hand, her warnings about financial imbalances and the risks associated with always caving to market expectations might resonate with a committee already buffeted by comments from Trump and administration officials. Most recently, White House trade adviser Peter Navarro specifically linked the Dow Jones Industrial Average reaching 30,000 with a Fed rate cut and Congress passing the reworked trade deal with Mexico and Canada. It closed Tuesday at about 26,787, close to its all-time high. Central bankers would probably prefer not to fuel the notion that they conduct policy based on the level of equity markets, or worse, because of political pressure.

In the end, it's Friday's jobs report that could potentially set up a showdown between the bond market and Fed officials or firmly cement a July interest-rate cut in both groups' minds. Either way, it ought to keep U.S. traders reluctantly glued to their screens after Independence Day.

From Bianco Research: Since February 1994, the Fed has had 201 planned meetings plus other gatherings where they made changes to monetary policy. Once a meeting is only 27 trading days away, the market has correctly predicted the Fed's actions 87% of the time. “Since 1994, we cannot find an instance when the market's implied odds hit 100% within 35 days of the next meeting without the Fed delivering,” Jim Bianco, the firm's founder and president, who also writes for Bloomberg Opinion, wrote in a research note.

For those interested in precise correlations, this from BMO: "The historical forecasting power is somewhat modest with an R2 of 0.23...if we restrict to the 'actual release values' (i.e. exclude revisions) the correlation weakens even further to an R2 of 0.12."

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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