Our Fixed Income team unpacks their views around the recent FED action.
As recent as November 2018 we were comfortably in Policy normalization mode in the U.S. The Federal Reserve Bank (FED) in the U.S. was withdrawing the monetary stimulus of the last decade by hiking rates and shrinking its balance sheet given their dual mandate of maximum employment and stable prices. The labour market was viewed as strong (arguably too tight) and prices were rising, albeit gradually. The FED gave the market the strong impression that they would continue tightening as long as the data permitted. Hence the market behaved like any drug addict who is coming off suppressants when this direction was changed.
In our view, in the December FED meeting the language inexplicably changed fairly radically for a Central Bank who historically prided themselves on forward guidance and transparency as a means of reducing volatility. They moved from tightening subject to data dependency, to a patient approach (even suggesting tightening may be over) without the very data they are dependent on having changed. This is to say wages are still rising, prices are up, fiscal policy is fairly stimulatory on the back of the Trump tax cuts and job creation remains strong etc. So, what has changed?
Have they changed their model or reaction function? Chairman Powell alluded to concerns about the global economy being under pressure. Normally the U.S. leads the globe, not the other way around. In addition, Yellen has emphasised that the FED focuses on their mandate and not what is going on in the rest of the world. Indeed, a famous FED governor once said something like “it’s our monetary policy, but the rest of the worlds problem” when asked whether they consider the impact of their actions on other countries. So, we don’t buy the view that the FED are reacting so strongly to developments elsewhere in the world. What else could it be? The two things that spring to mind are both market developments locally in the U.S. – namely the falling equity market and the near inverted yield curve. Both of these may portend challenges for the U.S. economy in the future, however it would be somewhat unprecedented for a Central Bank to respond to market developments rather than real economy data. Also, it is very rare for them to be proactive i.e. in front of the curve or anticipatory. They are traditionally at best coincidental or more likely reactionary.
Either the FED has seen something wrong in the data that not many others are seeing, or they have changed their model and the way they think about neutral real rate for the U.S. economy?
In H2 2019, they will either prove to be right or wrong. If they are right, the economy will be slowing (perhaps even entering recession). There may be a temporary period of risk markets rallying like they are now as the threat of further policy tightening is removed, but that could give way to the realisation that the global economy is slowing down and policy makers have little in the tool box to fight it this time and the debt burden globally has risen significantly since the previous crisis. This is risk-off for equity markets certainly, but mixed for Fixed Income markets, with falling yields but rising risk premia. If they are proved wrong and the data in the U.S. continues at a strong pace, they will have to restore the tightening of policy which then implies markets are back in the movie of H2 2018 as rates rise and liquidity is withdrawn. This is risk-off for fixed income, while tactically good for U.S. equity market until the FED potentially go too far.
Either way, things look a little ominous and we anticipate that risk / volatility will now remain elevated for the balance of the year as no one knows the FED reaction function. In such an environment we remain cautiously positioned and continue to use diversified sources of return to consistently build on alpha through market cycles.
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