Morgan Stanley: The Fed May Be Left with One Option

Morgan Stanley expects the Fed will gradually move back to the zero interest rate policy it had between 2009 and late 2015. Furthermore, it hasn’t ruled out nominal rates falling into negative territory. In a note, MS economist Ellen Zentner wrote, “Taking a walk through Chair Powell’s checklist of factors the FOMC will be looking at when deliberating policy adjustments going forward, it seems to us there is already a clear need to cut rates further.” In fact, the CME Fed WatchTool estimates there is an 83.5% probability the Fed will reduce the funds rate by 25 basis points at its September meeting.

Morgan Stanley: The Fed May Be Left with One Option

Morgan Stanley: The Fed may be left with one option

The yield spread (the difference between the ten- and three-year Treasury yields) turned negative in March. In the last five decades, whenever the spread has turned negative, a recession has occurred. Although the chances of a recession may not be high, the current slowdown could hurt the US economy. The trade war is disrupting the supply of raw materials and boosting input costs for US companies. Therefore, companies may cut their production, resulting in slower economic growth.

Trade tensions are prompting companies to move production facilities out of China to other Asian countries, far from the Trump administration’s objective to bring US trade surplus down. Moreover, the situation could deteriorate further for US companies that rely heavily on China. The tariff war could be a top political agenda in the 2020 US presidential election.

The Fed may not have any option but to reduce rates further to support the economy. Morgan Stanley’s Zentner wrote, “However, based on our economists’ forecasts for Fed policy, we don’t have an aggressive Fed today. Instead, we have a Fed that is easing policy almost as gradually as it tightened it.”

Looking at yield

With the possibility of more rate cuts, investors should consider high-dividend-yield stocks. The Utilities Select Sector SPDR ETF (XLU), with a dividend yield of 3%, may be an option. There’s also the Alerian MLP ETF, which offers an 8.5% yield. Ten-year government bonds offer a yield of 1.63%, and the S&P 500 (SPY) has a dividend yield of 1.9%. The S&P 500 also offers possible price appreciation. Moreover, gold could be a better hedge in the current environment. The Financial Select Sector SPDR ETF (XLF) could be impacted by any fall in interest rates—banks’ profit margin depends on the Federal funds rate.