FOMC Preview: Powell will meet, but struggle to exceed, expectations – The key focus for markets this week is the July FOMC meeting, which concludes on Wednesday. We and consensus look for a 25bp cut at this meeting, though there is some residual market expectation for a 50bp cut (none of the analysts surveyed by Bloomberg expect such a move). Given the dovish signalling from officials, the weakness in forward-looking indicators (particularly for manufacturing), and the persistence of downside risks to the outlook, we think a 25bp cut is a done deal. However, even the most dovish members of the committee (such as St Louis Fed President James Bullard) have expressed scepticism over a 50bp cut, so such an aggressive move looks unlikely.

The question therefore will be to what extent the Fed signals additional easing steps beyond what was signalled in June. With no update to the Committee’s projections at this meeting, it will be up to Chair Powell to steer market expectations via the press conference. Given that this will be the first rate cut since the financial crisis, Powell will likely want to make a robust case for the move, and will sound accordingly dovish. We expect the emphasis to remain on the downside risks to the outlook, but reference will also be made to muted inflation and the possible de-anchoring of expectations, as well as the weakening in business confidence. All of this should support expectations for rate cuts, but we suspect he will struggle to ‘out-dove’ the market at this stage given what is already priced in (a further 65bp in cuts beyond the expected 25bp July move). We continue to expect an additional two 25bp cuts by Q1 2020 following the expected July cut.

Higher recession risk bolsters case for rate cuts – While Chair Powell is unlikely to refer explicitly to this, one development that gives us greater conviction in our expectation for rate cuts is last Friday’s Annual Update to the national accounts which accompanied the Q2 GDP release. As well as a surprise downward revision to Q4 GDP growth (to 1.1% qoq annualised from 2.2%), the revisions also showed a significant fall in the estimate for corporate profits, with a corresponding upward lift in employee compensation. As such, corporate profit growth went from an estimated rise of 3.4% yoy in Q1 to a fall of 2.2% yoy. Outside of periods with sector-specific shocks (for instance, the fall in oil prices pressuring the shale sector in 2014-15), persistently negative profit growth has typically preceded corporate retrenchment (i.e. falling investment and job layoffs), and therefore a recession. Indeed, labour market indicators by themselves are usually lagging, and only show weakness once the economy is already in a recession. The revisions to corporate profits therefore make the risk of a recession look bigger than previously thought. While not our base case scenario, this heightened risk of a recession bolsters the case for Fed easing.