The FOMC unanimously decided on no policy action upon the conclusion of their January meeting, which was as expected.
The formal statement noted continued strength in the labor market and economic activity rising at a ‘solid’ rate (downgraded from December’s ‘strong’). While household spending has continued to grow, a slowdown in business fixed investment last year was also mentioned. Notably, the committee’s description of being ‘patient’ about determining future changes was newly inserted into the brief note, in consideration of both muted inflation but also global economic and financial developments as of late. In fact, all mention of the ‘gradual increase’ path for interest rates was removed, which was telling.
Interestingly, one change for 2019 is that the Jerome Powell-led Fed will host a press conference with Q&A after all eight meetings, as opposed to only after the four quarterly ‘formal’ variety in past years. While this may not have a major impact on policy, it could give the FOMC more latitude to make more controversial decisions at any of these meetings, since they’ve tended to do so only when a media backdrop was available to further clarify aims. In contrast to the Fed of old, communications and ‘forward guidance’ have become important pieces of their toolkit.
Volatility in several segments over the past few months—including financial markets (volatile stock prices and wider credit spreads), the political environment/government shutdown, trade policy between the U.S. and China and a continued strong dollar—have also added to a general headwind of tightening financial conditions. Such a tightening in overall conditions serves a similar purpose to the Fed raising rates directly, by tapping the brakes on the economy—which can either help the Fed, by doing the job for it, or acting as a hindrance in other cases.
There has also been speculation as to whether the Fed would slow the pace of drawing down their balance sheet of treasury and agency mortgage-backed securities (which it did not, but remains prepared to ‘adjust the details’ of this program over time as needed). Beginning in Oct. 2017, the Fed began the process of unwinding the large quantitative easing program by letting a pre-determined amount of bond assets mature (up to a cap, which has increased in stages), which allows the reduction to be done gradually and avoid market distortions. Since peaking at around $4.5 tril. at the time of the drawdown program’s inception, the current balance sheet size has declined to $4.0 tril. Interestingly, the gradual pace of these drawdowns has not seemed to disrupt bond market supply/demand dynamics on the surface. However, while this has been put in place as a ‘normalization’ program, intended to eventually get the Fed balance sheet to far lower sustainable levels, it does have the impact of ‘tightening’—as increasing treasury/MBS supply and reducing reinvestment demand could have the technical effect of raising interest rates, all else equal. Somewhat fortunately, in a world of low overall interest rates throughout the developed markets of Europe and Asia, other global buyers had stepped in to fill the gap—especially since the cost of currency hedging was reasonable (those low costs have dissipated since, making this a less attractive trade). Long-story short, the Fed may elect to alter their pace of balance sheet drawdown should additional signs of economic slowing occur, resulting in less possible upward pressure on longer-term rates, but also keep the balance sheet bloated for a longer period of time. It’s no secret that the Fed would prefer to keep the balance sheet ‘purer’ by only holding treasury debt, and unload the unique pile of MBS, and removing the more politically-charged implied support of housing markets (which is not in their mandate).
Probabilities for rate hikes in 2019 have fallen sharply, down to about 25% for June and 30% for December (with the latter also including 5% odds of a rate cut—a recently added twist). The laundry list of Fed mandate items hasn’t changed radically over the last few meetings, other than concerns over growth having increased:
The strong growth of 2018 was driven by prior tax cut legislation, boosting corporate earnings numbers, as well as the harder-to-measure impact of the administration’s loosening of the business regulatory environment. GDP for Q4 is expected to be in the range of 2.0-2.5%, with full year 2018 growth somewhere in the neighborhood of 2.5-3.0%. This is not expected to continue in coming quarters, as the positive base effects of tax cuts wear off and are overtaken by fundamental factors. Interestingly, while the government shutdown may play a minor role in trimming growth for Q1 2019 by a few tenths of a percent, and some businesses have been weary to expand in light of tariff uncertainty, the strong U.S. dollar has been a primary culprit mentioned in company earnings calls as the toughest hurdle. The policy impact is that more tempered economic growth going forward would naturally result in a lessened need for the Fed to keep its foot on the brake, endorsing the estimates of fewer rate hikes going forward.
Just as growth has slowed, fears of built-up inflation pressures have also waned. The most recent Government Inflation Report for December showed headline CPI coming in around 2.0%, which coincidentally falls within a tight range of outcomes over the past several calendar years. This is following a divergent 2018 where headline inflation was driven in both directions by a volatile oil market, while core inflation, sans energy and food, stayed relatively consistent. Being essentially the key component of the Fed’s mandate, balanced inflation around the 2% target would validate a lack of policy action—as pressures were neither worryingly deflationary nor inflationary. The strong dollar has certainly contributed to this to some extent, as it depresses import prices, while a weakening of the dollar and/or impacts from imposed tariffs could push inflation higher indirectly through outside channels.
Labor markets remain strong, as measures such as JOLTs job openings, the unemployment rate (and U-6 underemployment rate, perhaps as importantly) and jobless claims continue to run at peak levels not seen in decades. Consequently, it would take a substantial deterioration to bring these numbers back towards ‘average’, although such trends can coincide with rising recession risk when they do occur, so are closely watched. Strength in employment at this moment would serve to press the Fed to the keep rate increases going.
Investment markets either operate in unison with economic conditions, or, more often, experience price swings in spite of it. While equity bear markets, like the one seen in Q4 (although it officially missed by two-tenths of a percent, ‘only’ falling -19.8% from peak levels), can coincide with upcoming recessions, this isn’t always the case and can provide false signals. Equity earnings will likely not surpass their peak of last year on the back of tax cuts, but remain decently positive, with 2019 growth expected to be close to long-term average levels. Such conditions, along with better starting valuations following the said bear market, have historically been associated with positive expected returns from stocks. This remains good news, even if returns fall at below-average levels compared to the past few decades, and below exceptional post-Great Recession recovery returns of the past ten years.
Bonds, where sentiment has suffered for many years, based on low yields and investor fears of rising rates, have been seeing more ‘interest’ now that rates have risen and equities showing greater volatility. In particular, short-term assets like cash, which was cast aside as ‘trash’ when it paid literally zero, have been rediscovered at rates of 2% or better. Of course, this goes along with the flattening of the yield curve and related probabilities of the U.S. economy moving into late cycle. Despite short-term bonds offering good attributes at times like these, intermediate-term and longer bonds also serve a place in portfolios, with their historical lack of correlation to risk assets—helpful when conditions turn sour, as they did last quarter. Foreign assets of all types have also been disregarded, due to weaker prospects than those in the U.S., but cheaper valuations and poor sentiment have often correlated to stronger long-term return prospects.