What We’re Focused on Ahead of the Fed’s Policy Decision

With the Federal Reserve policy meeting happening this week, Dynex Capital is keeping our eye on the potential near- and long-term implications of the first significant rate cut since the COVID-19 pandemic.

But, how deep a cut will it be? Speculation swirls around whether the Fed will implement a cut of 25 or 50 basis points, which will set the tone for future rate cuts that could invigorate the economy.

With market conditions showing favorable momentum, here are four things we’re watching for as the Fed looks to avoid cooling upward-facing economic trends with its policy decisions.

How big will the rate cut be?

If recent comments from Federal Reserve Governor Christopher Waller are any indication, there will be a rate cut, with debates raging on how significant the cut will be. Any rate cut today is likely pacing toward an investor-anticipated total cuts of 75 to 100 basis points by the end of 2024.

Fortunately, the market has already done some of the easing for the Fed as 2-year and longer Treasury yields have come down 100-150 bps since a peak earlier this year, making a more conservative quarter-point rate cut a close second option.

What will drive rate cuts?

Our indicators point to US Treasury bond yields, falling mortgage rates and lower borrowing costs as the primary influencers in the pending rate cut.

The average yield on US treasury bonds is about 3.5% - while we can use more precise forward rate markets, this broadly implies the Fed will cut about 200 bps over the next few years from today’s 5.5% level. Mortgage rates hover near 6% - as low as they were in September 2022. Equities are also reflecting lower future borrowing costs for corporations and lower discount rates. Liquidity, while modestly tighter due to continued Fed quantitative tightening, is still readily available.

Additionally, labor markets remain remarkably resilient as wage growth remains positive, modestly above pre-pandemic levels. Our research indicates wage growth is the long-term fuel to tame inflation as it is related directly to consumer spending.

What are the long-term implications and consequences for the market?

Investors are looking for confirmation that the Fed is on track to cut rates – even if the pace is slower than expected. The magnitude of this cut will set the stage for future expectations, offering a window into the Fed’s policy outlook for this easement cycle.

These lower rates could spark an uptick in borrowing, risk-taking, and asset valuations. If the Fed does not deliver as expected, market pricing will change across fixed-income and riskier asset classes.

Investors will also keep an eye on falling equity valuations, which have historically eroded consumer and business confidence, and lead to a correction in labor markets.

Overall, the Fed must manage the delicate balance between its current actions and market expectations to keep financial conditions as positive as they are. Core inflation is the closest it has been to the Fed’s 2% target in three years.

What’s the Fed’s message?

Quantitative estimates from the Fed’s decision will be available, so Dynex will be keyed into Chair Powell’s messages that will drive the future pacing, magnitude of actions, and shape of the yield curve. We’ll also be tuning in to see the market reaction, especially how risky assets behave in the aftermath.

As always, we’re preparing with scenario analysis, an open mind, and a liquid, flexible balance sheet.

Stay tuned for our thoughts post-meeting.