In one of the more anticipated Federal Open Market Committee (FOMC) meetings in recent memory, the US Federal Reserve kicked its easing cycle off with a 50-basis point rate cut on Sept 19, Singapore time.
While it was the subject of much debate, the size of the reduction is secondary, says Tom Porcelli, chief US economist at PGIM Fixed Income. “More importantly, it marks the recalibration of US monetary policy to an environment of lower inflation and steadily moderating growth.”
The mixed message of a larger cut now, with two 25bp cuts expected through the remainder of the year, elicited a subdued market reaction with the US yield curve continuing to slightly steepen, notes Porcelli, who began his career at the Federal Reserve Bank of New York working on the open market desk.
Although the Fed clearly laid out its easing expectations for the remainder of the year, Porcelli says in a Sept 19 note that it is possible that further weakening in the labour market — as well as the knock-on effects into retail spending — could “challenge the view” of a more moderate easing trajectory.
However, the Fed has clearly indicated that it will shift policy as needed with the incoming data, he adds.
“While the decision to cut by 50bps was close — the distribution of the ‘dot plot’ was almost evenly split — the parity belies what may be a straight-forward reaction function. If payrolls keep coming in soft, the argument for going with larger cuts will be apparent to the other half of the distribution — and the opposite will be true. The calculus may be that simple for this Fed,” he writes.
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Terminal rate
The kickstart to the Fed’s easing cycle turns the focus to the perceived neutral rate and the time horizon needed to get there, says Porcelli. “Much as we anticipated, the Fed also anticipates another 100bps of cuts through 2025. This indicates that front-loading cuts may enable a more moderate easing pace with the Fed funds rate projected to reach a terminal level of 2.9% by early 2026.”
However, Porcelli believes the Fed may arrive at its terminal rate “sooner than it currently projects”, based on the incoming data. “At this point, the market is pricing in arrival at the terminal rate by September 2025. In sum, a policy shift that arrives at neutral sooner may be warranted to extend the current cycle of economic growth.”
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The time has come
In Porcelli’s view, US fixed income markets exhibited a relatively muted reaction to the historically-large rate cut.
“Fed Chair Jerome Powell clearly communicated the Fed’s recalibration strategy for returning policy rates from restrictive territory to neutral. Consequently, outright Treasury yields oscillated within local ranges and the long end cheapened by 5bps. Today’s Fed action strengthened the larger macro theme of steeper global yield curves,” he adds.
As previously mentioned, the Fed lowered expectations for policy rates by 75bps for each of the next two years and expects to approach its long-term target rate by the end of 2026.
As economic data have deteriorated, forward market rates have rallied more than 150bps since June. If the Fed achieves its projected glide path, these long-dated forwards seem “reasonably priced”, says Porcelli.
As the Fed has clearly communicated, the size and scope of further accommodation will be dictated by incoming economic data, he notes. “Should inflation or employment data deviate from recent trends, expectations for both forward rates and volatility may also need to be recalibrated.”
