The Fed's Rate Cut: A Controversial Move?
In our latest Rates Outlook for 2026, we explore the recent Fed decisions and their impact on the financial landscape. While the Fed's rate cut had some hawkish undertones, Chair Powell's focus on the labor market over inflation risks raises eyebrows. And here's where it gets interesting: the outcome hints at a potential return to quantitative easing, with the Fed considering extending its reach to 3-year Treasuries if necessary.
A Normalized Funds Rate?
The recent FOMC meetings have a common thread: rates are converging towards a potential landing zone, even if it's temporary. With the balance sheet on hold and the funds rate approaching a more 'normal' level, let's break it down.
First, let's talk about the funds rate and floating rates. The 3-month SOFR rate has finally dipped below the 10-year SOFR rate, making it more cost-effective to fund floating rates than fixed rates. This shift has been influenced by the rising pressure on the 10-year SOFR rate and the taming of the 3-month SOFR rate due to the rate-cutting narrative. It's a significant change from the second half of 2022 and January 2025, and it's expected to solidify further with the Fed's upcoming 25bp cut.
For those hesitant about swapping to floating rates due to carry concerns, this move provides a welcome relief, at least as long as the 10-year SOFR rate remains elevated.
Liquidity and the Fed's Balance Sheet
The liquidity conditions have been a point of concern, with repo rates trending tight. The effective funds rate's de-anchoring and its movement towards the rate on excess reserves (now just 1bp below) prompted the Fed's reaction. At the previous FOMC meeting, the Fed proposed freezing the balance sheet, matching further MBS roll-offs with T-bills buying.
However, the Fed's ultimate goal is to re-expand the balance sheet at the same pace as the nominal economy's growth. If nominal GDP grows at 3-5%, bank reserves should follow suit. To ensure ample reserves, the Fed has implemented flexibility to buy T-bills in excess of the MBS roll-off.
The Fed's T-bill buying agenda is described as 'reserve management purchases,' allowing them to venture into 3-year Treasuries if needed. This approach deviates from a pure T-bills buying program and leans towards quantitative easing. They plan to start with $40 billion in purchases, suggesting a gradual reduction later due to seasonal liquidity considerations. A positive development for the front end!
Thursday's Market Watch
Turning our attention to Thursday's events, Europe offers little notable data, but the US is set to publish trade balance data for September and weekly jobless claims. Analysts predict jobless claims to rise to 220k from the previous 191k. Additionally, Bank of England's Andrew Bailey will discuss financial stability.
In terms of issuance, Italy plans to offer 3Y, 4Y, and 5Y BTPs totaling €5 billion. The US will auction a 30-year Bond worth $22 billion.
And This is the Part Most People Miss...
The Fed's recent moves have sparked debates among economists and investors. While some argue that the Fed's actions are necessary to stabilize the economy, others believe it could lead to unintended consequences. What's your take on the Fed's rate cut and its potential impact on the financial markets? Share your thoughts in the comments and let's spark a discussion!
