The market expects that The Federal Open Market Committee (FOMC) to approve a quarter-point reduction at the Oct 29–30 meeting that will set the funds rate down to the 1.5% — 1.75% range. In September, FOMC had cut the federal funds rate from 2.00% to 1.75%, another move following the July rate cut.

What happened after the last FOMC meeting?

Recent data indicated a slowing economy, but not a recession, as shown in the September ISM surveys that both manufacturing and non-manufacturing sectors are dropping. The unemployment rate fell to 3.5 percent, while wage growth has slowed to 2.9% YoY; the US Consumer Price Index (CPI) was flat, with consumer prices unchanged. A decelerating economy and flat inflation will likely result in further rate cuts, and the Fed is purchasing more securities to keep up the short-term lending markets’ liquidity.

On the bright side, the US-China trade war has eased partially. The agreement reached by China and the US on a tentative “phase one” deal hints that a real breakthrough may be achievable in the next few weeks. Q3 earnings reports are also coming in better than expected. Over 80% of 124 S&P 500 companies reported that their Q3 results have beat the EPS estimates (as of Oct 23, 2019).

Figure 1: ISM surveys — Source: Macrobond, ING

What’s more?

According to Fed Funds futures, there is a 90% probability that the Fed will cut rates by 25 basis points. Historical data shows that in the past 10 years, the Fed has very few unexpected decisions beyond market expectations. The Fed is expected to cut interest rates next week, but that would probably be the last of such move for a while, according to Goldman Sachs.

Is it possible that a recession won’t happen?

The 10-year/2-year yield curve has dropped to the negative field between Aug 26–30, a first since 2007. Now that the yield curve has become un-inverted, leading to a situation in which long-term rates are lower than short-term rates. The 10-year/2-year version of the yield curve has preceded each of the past five recessions, including the most recent Financial Crisis between 2007 and 2009. However, the below graph (Figure 2) showed that 1998 was an exception.

Figure 2: Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis

In fact, 1998 was the only time after the yield curve was reversed in the past 40 years where no recession happened. It was largely due to the Fed’s quick response to cut interest rates after the curve was upside down, rather than waiting when the economy has clearly weakened. In 1998, The Fed began to cut interest rates only 18 days after the first inverted yield curve appearing (at the end of Sep 1998). During 1998 interest rate cut cycle, the US 10-year and 2-year government bond rates all declined, but both bottomed out before the end of the cycle.

Moreover, there normally are significant lags between yield curve inversion and recession. Fed Chairman Jerome Powell’s “mid-cycle adjustment” is suitable for current economic conditions.

Figure 3: The lag between inversion and recession — Source: FRED, OPCM

Which asset classes will outperform?

Judging from the interest rate of 10-year government bonds in major developed countries, the continuous decline in yields has become the norm. The ever-increasing amount of negative-interest government bonds may drive investors’ pursuit of higher-risk assets. In addition, the money supply that central banks have flooded over the past decade has allowed high-risk assets to be injected with sufficient funds.

Under current dovish monetary policies, equities can still produce decent returns in a non-recessionary slowdown. Looking back at the returns of multi-assets in 1998, equities performed better than bonds and commodities. And Blackrock data shows that the S&P 500 tended to rally, peaking on average 7.3 months after an inversion along the 2-year/10-year spread.

Gold benefited as a safe-haven asset this summer before pulling back from its recent September high, and the falling real yields benefited gold as well as Bitcoin since the opportunity cost to hold non-income generating assets has kept falling. Bitcoin as an “emerging store of value” may also benefit as a result of the higher-risk pursuit. We see Bitcoin as a more volatile, low correlation and better returns asset class today. Although bitcoin has lost 50% from its 2019 high, it’s still the best performing asset of the year with 90%+ return YTD.

Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.

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