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Fed and the markets on different pages

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      By Eric Stein, CFACo-Director of Global Income, Eaton Vance Management and Andrew Szczurowski, CFAPortfolio Manager, Global Income Group, Eaton Vance Management

      Boston - Wednesday's 25 basis point (bp) cut by the Federal Open Market Committee (FOMC) was highly anticipated. Nevertheless, risk markets sold off on the surprisingly hawkish tone of the post-meeting statement and press conference.

      Among the members, there were two dissents as Kansas City president Esther George and Boston president Eric Rosengren voted to keep policy on hold. The FOMC also announced the conclusion of quantitative tightening, with the balance sheet reduction ending in August -- two months earlier than planned.

      As for the future path of monetary policy, the U.S. Federal Reserve (Fed) and the markets are clearly not on the same page.

      What Powell said

      During the press conference, chairman Jay Powell avoided making any promises. Whenever he was asked how many more federal funds rate cuts we might get, he communicated that July's modest policy rate adjustment is intended to address a mid-cycle slowdown, not a full rate-cutting cycle.

      Instead of wondering what good the 25bp cut might do, he said the focus should be on the shift in Fed policy over the past seven months -- from a rate hike last December, to a pause, to a rate cut in July. Citing other cycles when the Fed made a few mid-cycle cuts, then later resumed hiking rates, Powell asserted that this rate cut doesn't mean a return to the zero lower bound. Zero lower bound is a situation that when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.

      Overall, Powell was fairly optimistic on the U.S. economy, although he referenced both below-target inflation and trade tensions. Given the Fed's objective to get actual inflation and inflation expectations higher by having lower real interest rates, we were surprised at how little he said about inflation. And while he noted multiple times that the trade war was having an impact on business confidence, Powell made sure to point out the Fed's job is to react to changes in the incoming data, not take sides in the trade dispute.

      How markets reacted

      The market had priced in three more rate cuts over the next year, viewing yesterday's action as the start of a prolonged easing cycle. So financial conditions tightened as risk markets had to come to grips with the Fed's unexpectedly hawkish communication that those cuts are not sure things. Stocks sold off, the US dollar rallied and the yield curve flattened -- with two-year yields jumping 10 bps at one point before settling up 3 bps.

      Bottom line: With a 25bp cut in the federal funds rate at the July FOMC meeting, markets got what they expected. But they were still disappointed at being left in the dark by the Fed, without certainty about the future path of U.S. monetary policy.