The Fed Can’t Seem to Satisfy Bond Traders or Trump

(Bloomberg Opinion) -- Who said it? “A small rate cut is not enough, but we will win anyway!”

The answer, technically, is President Donald Trump, who again this week fumed about the European Union and China on Twitter while lamenting that the Federal Reserve raised interest rates “way too early and way too much.” But it just as well could have been bond traders. Their initial take on Wednesday was clearly disappointment that the Fed cut its benchmark lending rate by “only” 25 basis points and ended its balance-sheet runoff. Two-year U.S. Treasury yields shot higher by as much as 5 basis points to 1.86% and the yield curve flattened. In another signal of the hawkish interpretation of the Fed's decision, the U.S. dollar strengthened.

The moves were only exacerbated once Fed Chair Jerome Powell began speaking at his press conference. He said the rate cut was aimed at “insuring” against downside risks. He noted that trade tensions almost “boiled over” in May and June but have since “returned to a simmer.” Overall, “the committee still sees a favorable baseline outlook,” he said, and, more important, that the committee is thinking of this move as a “mid-cycle adjustment to policy.”

“I'm contrasting it there with the beginning of a lengthy cutting cycle,” Powell said. “That's not what we're seeing now, that's not our perspective, our outlook.” Later, he said, “I didn't say it's just one.”

Markets simply wanted more. Before the Federal Open Market Committee meeting, bond traders were pricing in more than 25 basis points of easing, an indication that some were holding out for an even-larger 50-basis-point reduction. Not only did that not happen, but both Kansas City Fed President Esther George and Boston Fed President Eric Rosengren dissented in favor of leaving rates steady, raising questions about the path to further interest-rate cuts.

Then again, just because the Fed didn't meet the market's lofty expectations now doesn't mean it won't do so in the future. In fact, if recent history is any guide, it's only a matter of time before central bankers shift their stance to more closely reflect traders' positions. Alex Gurevich, chief investment officer at HonTe Investments, captured it succinctly in a Twitter post last month:

By all accounts, the first U.S. interest-rate cut in more than a decade should be enough of a victory for markets, given that in my estimation U.S. economic data is strong enough to merit keeping interest rates steady. Former New York Fed President Bill Dudley wrote in a Bloomberg Opinion column this week that he too sees risks in “needlessly stimulating the economy when it is already growing at an above-trend rate.” Scott Minerd of Guggenheim Partners was on Bloomberg TV just before the decision saying he didn't think lower interest rates were necessary.

Instead, bond traders are hoping to run up the score. They had priced in almost three quarter-point cuts by the end of the year. JPMorgan Chase & Co.'s Treasury client survey showed the highest level of long positions since late May, while separately, other strategists at the bank warned that a number of risk assets were flashing “overbought” ahead of the Fed meeting. Simply put, markets were set up for disappointment.

Still, I doubt the immediate reaction from this slightly hawkish decision will last. To continue Gurevich's pattern, the Fed may want to signal one 25-basis-point insurance cut, but the market will likely remain convinced that officials will further ease policy in the near future.

Powell has given little reason to believe he'll push back against market pricing, which is why bond traders and Trump figure they'll likely end up winning in the end. The FOMC statement reiterated that officials “will act as appropriate to sustain the expansion.”

It's also an important signal that the Fed ended its balance-sheet normalization early. I'm not sure it was the right move, given that just staying the course for two months would have been awfully negligible, and electing to tinker with the plan counters Powell's long-held stance that interest rates are the central bank's main monetary policy tool. But their rationale, I assume, is that it doesn't make much sense to be stimulating the economy through lower interest rates while also being seen as restrictive by paring down the balance sheet. It also sets up a clearer path to further lowering rates.

For now, one quarter-point rate cut straddles the line between those at the Fed who want to get ahead of any economic weakness and those who see little urgency to ease. But markets are forward-looking and will demand clarity on what's next.

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.