Fed changes tone, but will rate cuts deliver?

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      By Brian S. Ellis, CFACalvert Fixed Income Portfolio Manager and Vishal Khanduja, CFADirector of Investment Grade Fixed-Income Portfolio Management and Trading, Calvert Research and Management

      Boston - After its two-day June meeting, the Federal Reserve left the target range for the fed funds rate unchanged. Policymakers did replace language in the Fed's statement to downgrade "solid" growth to "moderate" and removed its willingness to remain "patient." Instead, the Fed pointed out increased "uncertainties" in its economic outlook, offering markets the suggestion it would be willing to cut rates.

      Objectively speaking, the change in the Fed's rhetoric reflects the fact that uncertainty is rising. However, we note that the Fed's statement called job gains "solid," the unemployment rate has remained low, and that "growth of household spending appears to have picked up." Indeed, while the Fed may view the economy's footing as less solid, the data gives the central bank little justification to cut rates yet.

      We think that Fed Chairman Jerome Powell is due some kudos. At a time where the market has been leading the Fed and questions abound about the central bank's independence, we think he has performed well by staying the course; he has steered a course that is practical in the face of increasing politicization. In the press conference following the Fed's statement, Powell remained noncommittal about a rate cut in July, showing that he is better at adjusting to a market that is in the driver's seat.

      As it stands, the odds of a July interest rate cut are at 100% based on the market's view. But as the Chairman emphasized, there is an enormous amount of economic data between here and the next Federal Open Market Committee (FOMC) meeting at the very end of July. We expect volatility to increase over the next six weeks as the market digests each economic release.

      We think market participants may be overestimating the efficacy of the Fed's monetary policy in this environment. There are very high expectations of the Fed, with hopes that rate cuts will be as economically stimulative as they have been in the past. There is little doubt that we are late in the cycle, so perhaps the Fed has bought itself some extra time with this statement. If we truly have macro weakness, we believe the Fed's tools will likely be less effective.

      If the Fed does relent and it provides the market with what it wants, our view is that the inflationary effects may emerge but that any rate cut may not truly be stimulative from a growth standpoint. Moreover, it is difficult to grow asset prices further today with U.S. stocks near all-time highs and corporate credit spreads very tight.

      All of that said, in the near-term, technical factors will likely drive valuations for bonds, in our view. Regardless of fundamentals, the expectation for easy policy should lead to technical support for risk assets, which are defined as any financial security or instrument that is likely to fluctuate in price. While technicals might protect valuations in the short term, the Fed may not be able to halt an eventual downturn. Our view is that the Fed can't accomplish much more with its monetary policy without fiscal policy working in tandem.

      On the other hand, we feel more positive about inflation breakevens, as a more accommodative Fed should support inflation expectations. Additionally, Chair Powell noted that the U.S. consumer remains very strong from a fundamental perspective. We agree and continue to be overweight consumer balance sheets, as low unemployment rates and support for wage growth should continue. For that reason, we view asset-backed securities tied to consumers as providing attractive spreads and potential stability for portfolios. Lastly, while the yield curve has already steepened and could steepen further as more economic data comes in, we may opportunistically shift our current short bias. We also think investors should consider maintaining extra liquidity to take advantage of the volatility we expect over the summer months.

      Bottom Line: We think this environment shows why fixed-income investors want to be diversified with their portfolios. In a time where uncertainty looks to reign over risk markets, we believe active management with a focus on security selection will likely benefit.