The US Federal Reserve has announced its long-anticipated interest rate cut – the first in a decade – as the central bank steps in to help boost the economy with the presidential elections looming next year. 
As widely expected, the Federal Open Market Committee revised the target range for the Fed Funds rate down by 25 basis points to the 2-2.25 per cent at its latest meeting on 31 July.
Whilst this may not have come as a huge surprise there is an unusual aspect to this rate cut and that is the difference of the global economy now compared to the last.
In 2008, the rate cut was part of the Fed’s plan to deal with the global financial crisis occurring alongside its quantitative easing programme aimed at shoring up the economy and banks following the onset of the global financial crisis.
Now, however, bull market conditions reign – with the rate cut likely to extend it – and the economy continues to grow albeit at a slower pace.
Effective Federal Funds Rate
“A desirable middle-ground choice”
Whilst US president Donald Trump has expressed his disappointment on the ‘too shy’ nature of Federal Reserve chair Jay Powell’s approach to rates, often tweeting his dissatisfaction.
Silvia Dall’Angelo, senior economist at Hermes Investment Management, said the move framed as an “insurance cut” and was justified by the Fed by the rising uncertainty surrounding the economic outlook, notably from abroad.
“The size of the rate cut seems to be the desirable middle-ground choice, as the Fed contends with a more mixed picture for the domestic economy,” she said.
“Indeed, recent economic data have pointed to a dichotomy between solid consumption – underpinned by a healthy labour market – and a wobbly business sector, just as the expansion has become the longest on records.
She added: “Deteriorating activity in the cyclically-sensitive manufacturing sector, reflecting negative developments in external demand and trade policy uncertainty, is cause for concern, and justifies a pre-emptive move. In addition, today’s rate cut can be seen as a simple reversal of the December rate rise, which some commentators – including a few at the Fed – saw as a mistake.”
One key element that Dall’Angelo noted was that this cut had “left the door open” for the Fed to introduce even more rate cuts going forward.
Indeed, colleague Andrey Kuznetsov –a senior credit portfolio manager –said that the change of tune in the Feds’ message concerning interest rates left room for more firepower, which he said would be welcomed by the market.
“This cut will make it easier for other central banks to ease, will dampen volatility across markets and will strengthen the technical support behind demand for spread products,” he explained.
“The shift in Fed rhetoric at the turn of the year proved to be a powerful tailwind for fixed income assets globally. Less than a year later the faltering global economy and unsettled trade disputes among other international issues necessitated the first cut in more than a decade.”
Are we back in 1995?
Jason Hollands, managing director at Tilney Investment Management Services, said that rate cuts are usually associated with periods when markets have sold off. Instead, the latest rate cut comes against a backdrop of strong performance for the S&P 500.
As such, he said there was a parallel for the latest rate cut with actions taken by the Fed in 1995.
“The 1995 rate cut took place against the backdrop of the S&P 500 index having posted a total return of 22.3 per cent since the start of the year, a rally eerily similar in scale to what we have seen so far in 2019,” he said.
Performance of S&P 500 YTD in sterling
Source: FE Analytics
Hollands said that after the 1995 cut more than 20-years ago the US equity market soared, providing the best year for S&P 500 returns within the last 50-years, as well as being followed by four stand-out years ranging from 21 per cent to 33 per cent. But, Hollands adds, that this was all followed by the 2000 dotcom bubble.
“Could the Fed have just fired the start pistol on a new bubble?” he asked.
“It’s possible. But before investors pile aggressively into equities it is worth bearing in mind the ongoing and considerable uncertainties facing global trade, factors which make 2019 very different from 1995,” he concluded.
What goes up comes down eventually
Rick Patel, portfolio manager at Fidelity International, said that so-called “insurance cuts” had been successful in 1995-96 when the Fed implanted three cuts in seven months, but had never been tried in a low-rate environment.
“In the current cycle, it is likely that, unless incoming economic data improves significantly during the next couple of months, a further cut will be implemented later this year,” he said.
“The Fed indicated that it will remain data-dependent in determining the timing and size of future rate adjustments, with the reference to ‘size’ indicating that a larger than 25bps adjustment remains a possibility as a next step.
“Thereafter, assuming that the cuts have at least some of the desired effects and inflation expectations move closer to the targeted range, we would expect the Fed to be very reluctant to use up its firepower before the next real recession hits.”