The prevailing opinion is the Federal Reserve will note the downside risks caused by the coronavirus and won’t cut rates in March, but bets are hedged for later in the year.
But some analysts say a rate cut will be needed soon. The coronavirus will strike at consumer confidence, which will cause a drop in spending, said Dan Geller, Analyticom LLC founder. “Since personal consumption makes up 70% of GDP in the U.S., the Fed will have to cut the funds rate to stimulate the economy and restore consumer confidence,” he said.
The illness “certainly has tilted the odds from a slight chance of a rate increase in the last week of January to a one in seven chance of a rate cut in mid-March,” said Robert R. Johnson, professor of Finance at Heider College of Business of Creighton University. “If the conoravirus becomes a true global pandemic and isn’t under control by the date of the Fed meeting, the Fed would likely cut rates in an attempt to stimulate the economy.”
"The Fed has to cut in March," said Mark Pacitti, founder of Woozle Research. Traders don't believe the Fed will be on hold this year and the market is "pricing in multiple rate cuts," he said. "The expectation is that the probability of a rate cut by the Fed is increasingly likely as the cornoavirus worsened." He noted after trade issues hurt the manufacturing sector last year, the Fed made preemptive cuts. "Even without the coronavirus, which of itself dramatically increases the chances of a Fed rate cut in March, you look around at the U.S. economy at the moment and see weaker-than-expected readings on consumer and producer inflation, jobs and manufacturing, which doesn't exactly suggest a rosy picture."
But, “only time will tell whether [the virus] is transitory or not,” noted Luke Tilley, chief economist of Wilmington Trust. “The Fed does not have any more insight than the rest of us on the spread and potential economic impacts, and I don’t expect they would say otherwise.”
As a result the Fed most likely will offer “cautious statements indicating it is a downside risk to growth but only time will tell whether it is transitory or not.”
A bigger issue is the recent yield curve inversion. While parts of the curve have gone negative, “the 10-2 spread is more important to the Fed, in our view, and that remains positive at about 18 basis points this morning,” Tilley said. “However, the recent moves have also inverted the short-end and belly of the curve, with all maturities from 1 to 7 years yielding less than the fed funds rate, which puts a bit of pressure on the Fed to lower rates. They are likely hoping that will unwind before their next meeting.”
“The containment effort in China and impact on its trading partners this quarter will likely have a significant, measurable impact,” said Steve Skancke, chief economic advisor at Keel Point and former Treasury staffer. “China’s Q1 economic growth likely will be 1%-1.5% lower and its trading partners likewise will be negatively affected.”
The Fed will measure “how much adverse impact this has on Japan, Korea, Southeast Asia, U.K. and EU economies.” Although “China's growth likely will catch up in subsequent quarters, there is uncertainty as to whether a similar catch-up will occur in the other economics — and hence in the U.S. economy,” he said.
Noting the elections later this year, Skancke said, there’s added pressure to not cut rates. “Moreover, with expected renewed Fed criticism from the White House to cut interest rates, the Fed will be particularly sensitive about reacting too soon to early data on coronavirus impact.”
While not its base case, Steven Friedman, senior global macroeconomist at MacKay Shields, said the Fed would need “evidence that the virus’ economic impact will be more significant and long-lasting than policymakers currently anticipate” to make a cut. “But it remains a fluid situation — it is still unclear how persistent, widespread and fatal this outbreak will be.”
And while March appears to be out, Friedman said potential remains “for a rate cut later in the year, to support the credibility of the FOMC’s change to flexible average inflation targeting.”
The impact of the illness will likely prove temporary, according to Michael Kelly, global head of multi-asset at PineBridge Investments. "The accommodation they already have put into the system is merely pumping up asset prices and that they need to hold as much as possible in reserve to fight off a long-lived recession one day. Expectations for a March wobble are misplaced."
The Fed would need to see the virus weakening “an already weakening economic environment,” before it would move, said Allen Sukholitsky, founder and chief macro strategist at Xallarap Advisory. “Prior to the coronavirus, we penciled in two cuts in 2020, with a greater likelihood of three than one. Depending on how severe the economic impact proves to be, we might start debating whether our base case should be three cuts.”
Despite the possible economic impact of the disease, Steve Frazier, president of Rhode Island-based Frazier Investment Management, said, "We believe strongly there would be no reason for an interest rate cut in March.”
With a data-dependent Fed, and “economic numbers [that] continue to be acceptable,” he said, “It would be hard to envision such a quick slowdown to warrant such a knee-jerk reaction from the Fed. If the virus lingers and continues to slow economic drivers both globally and domestically we can see an interest rate cut being considered for the June meeting."
Data
Factory orders grew 1.8% in December, the Commerce Department reported Tuesday, after a downwardly revised 1.2% drop in November. Excluding transportation, orders rose 0.6% after a 0.2% rise the month before.
Economists polled by IFR Markets expected a 1.2% rise in orders.
New York purchasing managers reported better conditions, as the ISM-NY Current business conditions index improved in January to 45.8, still suggesting contraction, from 39.1 in December. The six-month outlook fell to 57.3 from 64.2 in December, while the employment index declined to 56.1 from 60.8 a month earlier.
Business sentiment improves
With the phase one trade deal signed and spending strong, business sentiment improved in the fourth quarter, according to the Citizens Commercial Banking Business Conditions Index. The index rose to 61.0 from 60.2, suggesting “growing confidence in the U.S. economy.”
“Progress toward the first phase of a China trade deal, more clarity around Brexit, improved consumer spending and a stable rate environment took some of the uncertainty off the table for business leaders in the fourth quarter,” said Tony Bedikian, head of Global Markets for Citizens Commercial Banking. “Of course, this quarter the coronavirus is having an impact on certain sectors and markets, but the overall economic trend so far is still positive.”
Fed hearings
The Senate Banking, Housing and Urban Affairs committee has set a hearing on the latest Fed nominees Judy Shelton and Christopher Waller for Feb. 13 at 10 a.m. in Washington.
