Why Did Financial Markets React as if the U.S. Federal Reserve Raised Last Week?

The U.S. Federal Reserve dropped its policy rate by 0.25% when it met last week, from a range of 2.25% – 2.50% to a range of 2.00% – 2.25%. This marked the Fed’s first rate cut since December 2008.

The Fed also announced that it would end its balance-sheet reduction program two months sooner than expected (which is another kind of monetary-policy easing).

Interestingly, financial markets did not respond to this news as expected.

When the Fed lowers its policy rate, borrowing costs fall and this usually stimulates economic growth. Investors normally respond by increasing their holdings in cyclically sensitive assets, like stocks and commodities, and by reducing their exposure to the U.S. dollar (which would be expected to weaken in relation to other currencies).

This time around, in each case, the opposite happened. In the immediate aftermath, equity and commodity prices fell and the Greenback rose.

Put another way, financial markets responded to the Fed as if it had actually raised its policy rate last week. Why?

The short answer is that markets are made at the margin.

While the Fed did lower its policy rate, some investors expected that it would drop by 0.50% instead of by 0.25%. Furthermore, U.S. Fed Chair Jerome Powell had sounded increasingly dovish about the U.S. economy’s prospects in the lead-up to last week’s meeting, so financial markets were looking for the Fed to provide reassurance that additional cuts would be forthcoming.

Instead, Powell classified last week’s rate cut as a “midcycle adjustment” and clarified that it was not intended to signal “the beginning of a lengthy cutting cycle.” Accordingly, the futures market reduced its bet from two more Fed cuts this year to one.

Now is a good time to remind everyone that none of this guarantees what the Fed will do next.

For my part, I continue to believe that U.S. economic conditions are deteriorating more than many market watchers recognize, and that the Fed will cut by more, and more rapidly, than it now expects.

Here are several reasons why I say that:

• The longer the U.S./China trade war lasts, the more its negative impacts will intensify. That will be especially true if additional tariffs are added, and to that end, last Friday U.S. President Trump threatened to add a 10% tariff on another $300 billion of Chinese exports if a U.S./China trade agreement isn’t reached by September 1.
• Consumer spending is currently keeping the U.S. economy going but the most recent U.S. employment data, for July, show that both average hours worked and average wage growth are slowing. Both of these trends make it unlikely that robust consumer spending will continue.
• U.S. inflation continues to consistently undershoot the Fed’s 2% target, even after the U.S. federal government delivered a $1.5 trillion tax-cut package last year while increasing its budget deficit to more than $1 trillion. The Fed acknowledged that it wants to see higher inflation, but I think it’s going to take a lot more than a one-quarter-point cut for that to happen. (Especially for financial markets that have grown addicted to much more powerful forms of stimulus.)
• The European Central Bank (ECB) is expected to start dropping its policy rate again, and that will make it the seventeenth central bank to cut this year. The Fed may need to keep lowering its policy rate just to prevent the Greenback from spiking against the world’s other major currencies to the point that it will inhibit U.S. exports.

Now let’s turn to the key question for readers of this blog: What does the Fed’s first rate cut in more than ten years and the market’s reaction to it mean for Canadian mortgage rates?

The five-year Government of Canada (GoC) bond yield, which our fixed mortgage rates are priced on, initially spiked higher after the Fed’s announcement. But that momentum proved short-lived, and it ended down for the week. This drop makes sense because GoC bond yields remain highly correlated to their U.S. equivalents, and that correlation means that if U.S. Treasury yields keep falling, we should see some concomitant downward pressure on our fixed mortgage rates.

The Bank of Canada (BoC) has previously indicated that it will be in no hurry to lower its policy rate, which our variable-rate mortgages are priced on, in response to Fed changes. Our recent run of stronger-than-expected economic data will likely reinforce the Bank’s patience, but at the same time, the Fed’s recent cut also leaves virtually no chance that the BoC will raise its policy rate any time soon. That means that our variable rates aren’t likely to move in either direction over at least the short term.  The Bottom Line: The Fed lowered its policy rate last week as expected, but its accompanying commentary positioned the cut as a midcycle adjustment and not as a sign that additional cuts were imminent. That positioning left investors confused and, based on the market’s reaction so far, appears to have reversed the stimulative economic benefits that would normally follow such a move.

The Fed’s move will likely push U.S. bond yields lower, along with the GoC bond yields that are correlated to them. If that happens, our fixed mortgage rates will move lower. Meanwhile, based on our recent run of stronger-than-expected data, the BoC isn’t likely to follow the Fed’s reduction any time soon, but neither is it expected to raise rates. That means that our variable mortgage rates are likely to stay where they are over at least the short term.