Rate Hike Pause: Why Did the Federal Reserve Change its Tone?
The Federal Reserve’s dovish turn at its policymaking meeting in January was a surprise for the markets. Citing “crosscurrents,” Federal Reserve Chair Jerome Powell indicated that Fed monetary policy was on hold as the committee assesses economic conditions. Stocks and bonds rallied, with the riskiest sectors of the markets rallying the most.
Yet only six weeks ago the Fed raised rates and indicated further tightening in policy was likely appropriate. What happened?
Slowing global economic growth
While a lot of people attributed the Fed’s more-dovish tone to the drop in the stock market near the end of 2018, that’s unlikely. Based on comments from various Fed officials over the past few weeks, it seems that the change in tone was the result of an accumulation of negative factors that threaten to stall the economy’s growth.
Specifically, the global economy has shown signs of a sharp downturn, with China and Europe feeling the pinch of the decline in global trade. In the United States, business and consumer confidence have softened, and financial conditions tightened. Throw in Brexit, a prolonged trade war, and a government shutdown, and you can build the case for a fairly negative outlook for the first half of 2019 or perhaps longer.
The tipping point for the Fed seemed to be the tightening in financial conditions here and abroad. While the U.S. economy is looking good, the U.S. unemployment rate is low and consumers are in good shape, the cumulative effect of the Fed’s rate hikes to date have no doubt contributed to the global slowdown. The Fed is essentially the central bank to the world, because the U.S. dollar is the world’s reserve currency. Consequently, when the Fed raises the risk-free rate in the U.S. it’s like a stone dropping into a pond—it ripples throughout the world, causing financial conditions to tighten. That was the case in 2018.
Fed’s pause eased financial conditions in early February
Source: Bloomberg. Bloomberg U.S. Financial Conditions Index+ (BFCIUS+ Index), Bloomberg Euro-Zone Financial Conditions Index (BFCIEU Index), Bloomberg Asia ex-Japan Financial Conditions Index (BFCIAXJ Index). Weekly data as of 1/31/2019.
Up until the January 30th Fed announcement, financial conditions were at the tightest since late 2015, the last time the Fed paused its rate hikes. That means businesses were paying higher rates to access credit, or in some cases not getting access at all.
Not surprisingly, risk assets responded favorably to the Fed’s shift. Emerging-market bonds and currencies rallied sharply, along with high-yield bonds. It wouldn’t be surprising to see the rebound continue for a while, but the underlying risks remain elevated in these markets.
Arriving at neutral
One of the big surprises in Powell’s comments was the implication that the federal funds rate—the rate banks charge each other for overnight loans, and a key lever for Fed rate policy—is now deemed to be at “neutral.” The neutral rate is the rate that allows the economy to grow without pushing up inflation or slowing it down toward recession. It’s an unknown number that can only be estimated. The market assumes neutral is close to the Fed’s quarterly estimates of the “longer-run” rate, which have held in the 2.5%-to-3.5% range for a number of years. With the federal funds rate now close to the lower end of that range, it appears that the Fed is saying 2.5% is neutral.
It may not seem like big news, because market pricing has already built in the potential for a rate cut in late 2019 or 2020. However, the apparent confirmation by the Fed that the rate hiking cycle may be over is likely to encourage expectations of looser policy down the road. This should encourage the rally in riskier assets.
The yield curve may steepen
A Fed pause is also likely to steepen the yield curve a bit in the near term, because it implies the Fed could tolerate stronger growth and higher inflation than previously anticipated. The yield curve did steepen in the week following the January meeting, although there is still a slight inversion between two- and five-year yields. Nonetheless, some widening of the spread between two-year and 10-year Treasury yields seems likely as long as the market is expecting the next move will be a cut.
The yield curve steepened slightly after the Fed meeting
Source: Bloomberg. Data as of 2/13/2019, 1/14/2019 and 2/13/2018.
However, if the Fed simply remains on hold and the U.S. economy slows as expected, with little inflation, then the curve will likely move back to flattening due to a drop in yields at the long end. In other words, in the long run we expect 10-year yields to move down to 2.5%. Expectations about the next move in Fed policy will be important.
Big balance sheet here to stay
To top off the already dovish policy shift, the Fed surprised the market with an update on its balance sheet reduction policy. This was a big surprise, since at the December meeting Powell indicated that the current plan of allowing bonds to gradually mature off the balance sheet was working as expected and added “I don’t see us changing that.” Yet six weeks later, the Fed released an update that implied the size of the balance sheet was likely to be larger than previously planned.
Some pundits accused the Fed of “caving” to pressure from the markets. However, there isn’t much evidence to support the view that the decline in the balance sheet is related to the market drop late last year. There has only been a $400-billion drop in the size of the balance sheet to date, excess reserve balances have been dropping for several years, and the plan was well advertised. Why would the market suddenly react to something that has been known for a long time?
More likely, the Fed’s altered view of the balance sheet run-off is recognition that structural changes in the banking system require the Fed to hold more reserves. Prior to the financial crisis, the Fed’s balance sheet totaled about $0.9 trillion. At that time, the Fed set the funds rate by adjusting the amount of reserves in the system. Reserves levels were low compared to today—at about $10 billion, with excess reserves at $2 billion— just enough to make the system function. The Fed is the only supplier of reserves, so when it wanted rates to move up it would drain reserves, and if it wanted rates to move down it would add reserves.
The Federal Reserve’s total assets and bank excess reserves grew after the financial crisis
Source: Federal Reserve Bank of St. Louis. All Federal Reserve Banks: Total Assets,(WALCL), and Excess Reserves of Depository Institutions, (EXCSRESNS), Millions of Dollars, Monthly, Not Seasonally Adjusted. Monthly data as of January 2019.
After the financial crisis, reserves ballooned to a level that made rate-setting more difficult, so the Fed moved to a system where it established a floor for rates, paid interest on overnight reserves, and used its overnight repurchase facility. The system was working well until the middle of 2018, when the funds rate kept bumping up against the top end of the range set by the Fed. The implication was that there weren’t enough reserves in the system.
Ultimately, the Fed is looking to find the appropriate level of reserves and assets to provide adequate liquidity to the financial system, while still managing to control the federal funds rate. The current thinking is that level is likely to be in the $3-trillion-to-$3.5-trillion region for total balance sheet assets, with reserves above $1 trillion. Those estimates are considerably higher than the estimates released in 2017, when the Fed last updated its plan. At that time, it estimated reserves in a range of $400 billion to $1 trillion, and total balance sheet assets at $2.9 trillion.
The bottom line
The Fed has shifted to an easier policy stance, which has direct implications for the fixed income markets. In the near term, riskier segments of the market will likely rebound, and the yield curve is likely to steepen somewhat.
We do not suggest chasing these trends, however. The longer-term trend towards a flattening yield curve should remain intact while the underlying fundamentals for high-yield and emerging-market bonds suggest a neutral stance at best. There is still too much corporate and emerging market debt to be serviced and refinanced to make us comfortable with a more aggressive stance. The dollar could weaken somewhat due to the softer Fed policy stance, but currencies are a relative game and it’s hard to find an alternative that looks attractive.
Depending on how the economy performs, this cycle of rate hikes may be over, reinforcing our view that the peak in longer-term rates is behind us. Ten-year Treasury yields will likely trade in a 2.5%-to-3% range for the next few months as the markets adjust to the new message from the Fed. We’re still cautious about the potential for volatility this year due to the “crosscurrents” the markets are facing.
Our suggestion for investors is to add bonds with intermediate-term maturities in the seven- to 10-year region for Treasuries and taxable bonds, due to the likelihood that intermediate- to long-term rates have peaked for the cycle.
We also continue to suggest staying in higher tiers of credit quality. With the economy slowing and yield spreads relatively low, the risk of lower-rated bonds getting downgraded or defaulting is rising.
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