*These number change constantly. This is as of 7/16/2019 8:09am.

The above are probabilities of a fed move implied from the market. The probabilities are derived from the OIS markets. The chart shows that the probability of a 25bp July cut is 124% (a full cut and some). The probability of a 50bp cut is higher than 50% as well which is definitely interesting.

We have had some large economic data releases recently. I will focus on today’s consumer data and the non-farm payroll.


Consumer Data:

We just had an amazing US consumer data come out today that has caused a selloff in the bond markets. 10 year yields are at 2.13 currently after getting to 1.95 recently. The US consumer’s recovery from the dark months of Winter (gov’t shutdown stock market sell off etc) has continued into June.  All this talk about trade war having a major impact on the market is not resulting in any consumers being fazed. Retail sales ex-autos, as measured by BAC aggregated credit and debit cards, increased 0.3% month-over-month (mom) seasonally adjusted (SA) in June. The 3-month moving average softened in June as a strong March figure rolled off the calculations. That said, consumer demand has been on a hot streak in the past few months, posting impressive % mom gains and reversing the notable pullback in spending to start the year. Focusing

on the trend, the story is still clear: consumers’ wallets are still open. The big question facing market participants is whether the uncertainties posed by the trade war will impact consumer behavior. We have seen evidence of businesses delaying investment as a result but there has been little sign of it changing the equation for the consumer. As long as businesses are willing to hire and consumers feel secure in their jobs – as the labor market data suggest – consumers should be well positioned.

In theory, if the trade war was hurting consumer spending, we would expect that it would show up most acutely in the regions with a heavy concentration of manufacturing and agriculture jobs, particularly soybean production. This is because soybean has been the major target under the retaliatory tariffs from China.

I find no discernable difference in spending trends in these regions as compared to the rest of the country. In contrast, during the last manufacturing downtown in 2015, consumption in the manufacturing and soybean regions contracted, diverging with the rest of the country. This means that consumers are still spending at a trend pace even in areas at the epicenter of the trade war. We think this should lessen the worry about the spillover from the trade war to the domestic economy.


Non – Farm Payrolls :

Nonfarm payrolls rebounded and that lessens the chances for the Federal Reserve to cut its policy rate on July 31st.  Alternatively, this could position markets as excessively pricing cumulative easing with three cuts priced by the end of 2019.  Markets reacted by pumping short-term yields higher with the two year Treasury yield up 10bps on the day and half of that since payrolls and the USD firmer against all major currencies on overall lessened conviction toward the cumulative amount of easing that is priced in.

Private payrolls (+191k) were up by less than headline payrolls because of strong government hiring.  Government added 33,000 jobs in June, but not because of Census related hiring.  All of the hiring was at the state/local level (+31k) and overall temp hiring was only up 4k.  I don’t have a good explanation for the surge in state/local government hiring.

Wage growth was unchanged at 3.1% y/y against consensus expectations for an up-tick.  Scotia’s estimate was surprised on the high side for jobs but wage growth met Scotia’s expectations.

The rise in the US unemployment rate to 3.7% should be faded.  It’s always derived from the household survey, which posted +247k for jobs but a larger 335k increase in the labour force.  These are very volatile readings.


Fed Guidance:

Powell during his testimony to congress basically guided the market into thinking a 25bp cut is most likely going to happen. He had every chance to walk back the cut and focus on the great economic data and that progress is being made on China. He instead decided to capitulate on the fact that he said inflation movements recently were transitory and said that the non-farm payroll numbers did not affect fed outlook. Seems to me the main reason fed is thinking of cutting is as an insurance cut. I would not discount the pressure from the President as well. History is filled with instances when the president has forced the fed’s hand. This was the case in Nixon’s presidency when he forced Arthur Burn’s hand.

The main issue with the fed currently is that Powell told the market that he wants to see asset prices higher. The fed has a dual mandate where they want to see unemployment low and inflation at 2%. But they have now been fully focused on asset prices. Essentially you have the ‘Powell Put’. The problem with giving the market a free put option is that they will find the exercise price and force Powell the blink. This is why every time we have bad news , stock market rallies and bond market rallies. This is usually a recipe for disaster. It is unnatural for risky securities to rally on bad news. The reason they rally on bad news is because when we have bad news come out the probability of a fed cut goes up driving risk up as a result. It is counterintuitive. Bonds and stock should be inversely correlated. Stock prices should go down when bad news in the economy comes out. With bond yields moving lower you will have a scenario where money managers who need to provide yields to their clients start looking for other ways to achieve this. The last time yields were driven low by monetary policy we innovated and created new products to come up with yield. They were subprime mortgages. What will it be this time?

The above first chart of fed probabilities shows that we have several cuts priced in. It seems quite clear that fed wants to do an insurance cut to protect against any tradewar slowdown. Question really at this point is…will they cut again.


Here is a chart that could be used as a reasoning for a 50bp cut : the likelihood is very low.


A chart that could potentially point towards a 50bp cut in July. Fed needs to possibly recalibrate the real fed funds rate.. US 5y5y breakeven vs the real fed fund rate (core PCE). A point that has been echoed by many (economists/strategists and some non voter fed members) is that a 25bp cut would do nothing for inflation expectations if that is a concern for the fed.

The counter point to any talk of 50bp cut is that even the most dovish fed voter (bullard) has said there is no need  for a 50bp cut.

I don’t know what the fed will do or will any of these probabilities pan out. But historically when a significant amount of cuts have been priced in fed does end up cutting at some point. Let’s see what happens? Stay tuned for the meeting on July 31st to see how it pans out.

:For educational purposes only