Our Head of Corporate Credit Research explains why he expects the US Federal Reserve to make three rate cuts before the end of the year, starting in September.
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Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about why it's looking more likely that the Fed should, and will, cut interests rates several times this year.
It's Friday, July 12th at 2pm in London.
Last week, we discussed why the case for Fed rate cuts this year was strengthening. Credit markets generally don’t care too much about the exact timing or pace of policy rates, but they do care if a central bank is behind the curve.
That’s because over the last 40 years, the worst returns for credit have repeatedly overlapped with periods where the Fed was too late in reversing tight monetary policy. After all, interest rates impact the economy with a pretty long and variable lag; and a interest rate cut today may not be fully felt in the economy for 12 months – or even longer. It’s therefore important for a central bank to be proactive.
And so, with the recent US economic data softer, and the Fed appearing in little rush to act, the concern was straightforward: if the Fed is waiting for signs of economic weakness to be obvious, it will take too long to lower interest rates to blunt this. The Fed will be behind the curve.
This risk of acting too late hasn’t gone away, and it’s a key reason why we think credit investors should be rooting for economic data in the second half of this year to remain solid, in line with Morgan Stanley’s base case. But this week did bring some events that suggest the Fed may start to adjust rates soon.
First, in testimony before the US Congress, Chair Powell repeatedly emphasized that the risks for the US economy are becoming more balanced. Previously, the Fed had appeared to be much more focused on an upside scenario where conditions are hotter rather than a scenario where growth slowed unexpectedly.
Second, in data released yesterday, US Consumer Price Inflation – or CPI – came in lower than expected. Overall, prices actually fell month-over-month, something that hasn’t happened since May of 2020, a time when the pandemic was raging, and Fed rates were near zero percent. Morgan Stanley’s base case is that moderating inflation will lead the Fed to cut interest rates by 25 basis points in September, November and December of this year.
For credit, the question of “what do these rate cuts” mean is an ‘and’ statement. If the Fed is lowering rates and growth is holding up, you are potentially looking at a mid-1990s scenario, the best period for credit in the modern era. But if the Fed is cutting and growth is weak … well, over and over again, that has not been good.
We remain constructive on credit, expecting three Fed rate cuts this year to coexist with moderate growth. But weaker data remains the risk. For credit, good data is good.
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