We have had two rate cuts in 3Q, and at least one more is likely in the final two FOMC meetings of 2019.

Moreover, there is a high probability the Fed will be forced to cut rates significantly further in 2020. The thesis hinges on conflict between large budget deficits, a lack of foreign sponsorship for Treasuries, and primary dealer balance sheet constraints. Dealers have been absorbing the majority of coupon Treasury issuance over the last 18 months, and will continue to do so until they run into liquidity limits (in aggregate) by 1Q 2020. At that point, faced with private sector balance sheet constraints, the Fed will effectively have no choice but to launch QE—and leave itself vulnerable to criticisms that it is monetizing the debt—and to cut rates sharply. Sharp rate cuts would steepen the yield curve, reduce currency hedging costs, and encourage foreign buyers to reenter the long end of the Treasury curve. Given current market pricing, however, the Fed would have to cut overnight rates below 1% to materially steepen the curve. Depending on how conditions unfold, these cuts could return the economy to the zero lower bound.

About the author

Guy LeBas

Director, Custom Fixed Income Solutions

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