The Federal Reserve has cut interest rates for the first time in more than a decade, effectively putting monetary policy into reverse after raising interest rates four times in 2018. The move, which cuts rates to within a 2%-2.25% range, was largely expected.
“I believe this rate cut is already priced in. Given what is priced into the market already, we could see some short-term volatility, especially as we are in the middle of Q2 earnings reporting season and estimates for Q4 likely need to come down a bit. But from a medium-term perspective, assuming a 25 bp cut and “dovish” commentary leaving the door open to further cuts, the outlook for equities is quite positive as any reckoning for high government debt levels, negative real rates, etc. is pushed further into the future,” said Suzann Pennington, CIO, Foresters Asset Management. She also pointed out that it is unusual to see the Fed so specifically communicate a rate cut ahead of time.
Why cut right now?
The Fed raised rates in March, June, September, and December 2018 and was expected to continue raising rates this year as well. But sentiment shifted early this year.
“The biggest change was the trade war and lower than expected global growth,” said Imran Chaudhry, vice president and senior portfolio manager, fixed income at Foresters Asset Management. He points out that jobs numbers are strong and the economy is resilient, so the main fear was a slowing global economy.
Morningstar analyst Eric Compton says that if lower rates lead to a stronger economy, then this strategy could be better than waiting for there to be a recession before making the cut.
“There is a big difference between going to zero for the federal funds rate for over five years (which is what we did last time) versus having 1-3 interest rate cuts which will eventually reverse in a couple of years,” he said.
“The Fed has been more aggressive than the Bank of Canada. Today’s move is less of a divergence than a convergence to what Canada is doing,” pointed out Hans Albrecht, vice president and portfolio manager at Horizons ETF Management. He expects the Fed to keep lowering rates this year.
Chaudhry also expects another “insurance” cut from the Fed this year. An “insurance cut” is essentially a preemptive interest-rate cut, as opposed to a rate cut made in response to weaker economic data. Pennington points out that this type of rate cut has historically been very bullish for equities as the intent is to extend the economic expansion and prevent or delay a recession.
What about Canada? will Bank of Canada cut rates?
Based on this Fed decision, Albrecht believes not. But he believes that in the long run, all rates are heading drastically lower.
“Overall, Canada’s story seems more positive, but our underlying problems are more serious. Our economy is healthier, inflation is healthier than the U.S. or the EU. But we have fundamentally weaker things going on. Our debt-to-income levels are much higher than the U.S., while our household savings rates are very low,” he says. He explains that the U.S. will be able to withstand difficult times better than Canadians and says that the BoC would be better off making a mistake on the side of a cut than by raising rates, as Canada would be less able to withstand a raise.
Chaudhry, however, believes that the BoC could cut rates this year. “If the Fed cuts again, and I think they will, and the Canadian economy holds, which I think it will, then the BoC will cut rates this year. But it will be closer to the end of the year,” he said.
What Should Investors Do?
“For banks, lower interest rates are broadly a negative. Lower rates result in lower yields on earning assets, and this causes banks to earn lower interest income, decreasing their profitability. Lower rates on the long end of the yield curve can stimulate increased mortgage activity, which can result in more fees for banks. But, on the whole, lower rates would result in decreased profitability for banks,” Compton said.
“All else equal, the turn in the Fed’s sentiment on the target rate has restored the attractiveness of investment demand for gold, a sharp turn from the trend during the last few years. At present, we think the market is pricing in a scenario of a low to negative real interest rates from a weak economy that necessitates rate cuts, but at the same time, normal inflation stemming from a healthy economy—scenarios that appear unlikely to occur simultaneously. On the back of rising investment demand, gold prices have settled above US$1,400 per ounce, more than US$100 higher than just a couple months ago. Gold now sits above our forecast for a nominal gold price of US$1,300 per ounce by 2020,” says Kristoffer Inton, Morningstar’s director of basic materials.
For Canadian investors, Albrecht points to Canadian gold companies and Canadian banks as a good bet. “Canadian banks are giant money-making machines. Meanwhile, with gold prices rising, Canadian gold companies are in very good shape in Canadian dollar terms,” he said.
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