The US Treasury market rallied across the curve yesterday as geopolitical tensions intensified with the attack on the two oil tankers in the Gulf of Oman.
The short-end of the market is now pricing in three 25bp cuts to the funds rate this year and then nothing more, which is a little strange. Some argue for an ‘insurance cut’ as early as next week’s FOMC meeting sighting the Middle East situation, trade tensions and some further evidence of economic weakness, notably the last payrolls data. We feel a cut next week is unlikely; it is also unlikely that the Fed would cut three times and stop as the market is pricing.
The problem with expecting the Fed to cut three times and then stop is that there has only been one occasion since the Volcker era that the Fed has used policy in that way without some sort of financial incident. They have cut rates three times and then stopped on three different occasions: once due to the Black Monday stock market crash in 1987 and again in response to the Long Term Capital hedge fund blow up in 1998. It was late 1995 that the Fed under the chair of Greenspan cut three times and stopped and did actually manage to create an economic soft landing before tightening again in early 1997. Some will remember the period after Greenspan famously sounded off about ‘irrational exuberance’ in the market.
So this was the only occasion the Fed have acted in the way the market is pricing. Unless we are on the ledge of a recession (not many calling for that this year), or indeed some financial disaster is about to fall upon us, the market pricing has to be looked at as maybe a little concerning.