Last Updated on 27 January 2021 by F.R.Costa

After Powell’s testimony before Congress yesterday, the market moved to currently discount three rate cuts in the year. But, with the U.S. economy growing well and unemployment at a minimum, that’s odd.

From a record low level of 0.25% in 2016, the FED hiked its FED funds rate 9 times to the current upper band level of 2.5%. The financial crisis of 2007-2009 forced the FED to adopt a dovish policy, which started with rate cuts and was later complemented with quantitative easing.

Still, 10 years after the end of the crisis and despite the current boom being one of the longest the U.S. economy ever experienced, the policy rate is much below its natural long-term level, many times guessed around 4%.

What’s more shocking is the fact the FED is considering a precautionary rate cut amid looming uncertainty from the China trade war, the May tariff hike, fading fiscal stimulus and an inverted Treasury yield curve.

Well, much could be said on those grounds but, in my view, there’s no justification for rate cuts at this point. The unemployment rate in the U.S. sits at 3.7%, which is just 0.1% above last month’s numbers, which are levels not seen since 1969. The latest nonfarm payrolls report confirmed a strong economy, as 224,000 payrolls were added in July (figures above 200,000 are usually considered very strong).

Unemployment Rate U.S.
Source: FRED, retrieved using GRETL

GDP growth also give no clues about a need for rate cuts, as the economy was growing at a 3.1% annual pace in Q1 this year. The growth marks the 20th straight quarterly growth, as the last time the economy shrunk was on Q1 2014.

US GDP Growth
Source: FRED, retrieved using GRETL

The latest inflation numbers reported by the U.S. Bureau of Labor Statistics point to a rise in prices of 1.8% in May (year-on-year). After two years of inflation above 2%, the figure is stabilising more or less around 2% this year. While the FED doesn’t target these inflation numbers but rather an alternative figure based on personal consumption expenditures, the real truth is that prices have been rising and there’s a currently more upside risk than downside risk.

Rate Cuts Ares Being Discounted As Certainties

In summary, I can’t find economic justification for one rate cut, let alone three. In my view, President Trump is pressing the FOMC, threatening its independence but, sooner or later, Powell will cut the cord and do what he’s mandated to do. He’s not willing to fight market sentiment and opted instead to keep all windows open. But if major economic data continues to support a strong economy, rate cut expectations will end smashed by evidence.

The FED Watch Tool is discounting a high likelihood for three rate cuts this year. The odds for a rate cut occurring in the next meeting are 100%, distributed as 69.3% chance of a 25 bps cut and 30.7% chance of 50 bps rate cut. In other words, the rate cut is seen as a certainty. For the September meeting, the odds of the accumulated rate cut being by then 50 bps or more are 80.1% (55.6% plus 24.5%). For the December meeting, the odds for three accumulated rate cuts (of 25 bps each) are 58.0%. The market is discounting a chance of just 9.3% for one rate cut accumulated until that point.

fed watch tool

I don’t like playing guess games, but given the odds involved in the FED Watch Tool and the released economic data, I would be willing to take a bet against the crowd. After all, if rate cuts are being discounted as certainties, there’s not much to lose if the cuts don’t materialise.

Placing Trades Against The Crowd

To go against the crowd I want to set up trades that benefit from slower rate cuts in the U.S. than currently expected.

EUR/USD

I think Europe is a lot wore than the U.S. Over the last months the dollar has been rising against the Euro. The Euro has been losing its shine since the beginning of 2018 when it was valued at 1.25 dollars. It currently trades at 1.1271. While Trump will continue to insist on Europe is playing currency wars against the U.S., the real truth is that the European economy is a mess when compared with the U.S, which more than justifies the depreciation of the Euro. Thus, if interest rate cuts are missed, as I expect they will, the USD will benefit. I’m selling the pair EUR/USD at the 1.1271 level.

U.S. Bonds

Bonds are expected to benefit from rate cuts as yields and bond prices are inversely related. The part of the yield curve that is changing the most due to expectations of rate cuts is the short-maturity up to 3 years. The longer-term part is mainly unchanged. One way of betting against the rate cut is by short selling the 1 to 3 years part of the curve. One possibility is by selling short a bond ETF like the iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY). Still, it’s relatively tough to set up a short trade on bonds as a play on interest rates.

Gold

While it may appear controversial for some, I’m not optimistic on gold for the shorter term. Gold has been rising on the expectation central banks would resume rate cuts. It was in particular boosted by the possibility of the FED cutting rates three times this year. If rate cuts come short of it, gold may enter a correction and return to its May levels at 1,270, from the current 1,422.

About F.R.Costa

Filipe has more than 20 years experience with financial markets. He holds a degree in Economics with a specialisation in Finance and he's currently finishing a PhD in Finance. He used to work as financial consultant and research associate but then decided to return to academia five years ago. Since that, he has been an Invited Lecturer, teaching courses on Investments, Financial Markets, and Monetary Economics. He is also a regular contributor writer at The Master Investor Magazine.

View all posts by F.R.Costa