The dust is slowly settling after Wednesday’s FOMC rate decision, and more importantly the following press conference where Chairman Jerome Powell literally talked the market down.
The Fed still paints a rosy picture for growth in 2019, with GDP expected to rise by 2.3% (though down from 2.5% in Sept), inflation firmly under control with their estimate of preferred PCE measure actually falling to 1.9%, while the outlook for jobs remains robust. The Fed Funds rate was lifted by 25bp to 2.25-2.5%, taking it to the lowest internal estimate of ‘neutral’. The dot plots signalled a median of two further hikes for 2019, rather than the three the FOMC was projecting in September.
On the face of this outlook, the market reaction may seem strange, but the press conference revealed that the Fed was perhaps not quite as confident in its outlook as the statement initially suggested.
Powell acknowledged the risks to the economy were broadly balanced, as he stated that by being at the bottom-end of a neutral rate stance the Fed could be more patient over future hikes and that every hike was now data dependent.
Before answering several questions, where he knew his comments might appear negative, Powell repeated the Fed’s positive view on the economy, but then went on to let the markets know there was downside to its forecast too. He said there was “significant uncertainty about the ultimate destination of any further rate increases”.
Another interesting comment was that the winding down of the Fed’s balance sheet was “on auto pilot”, and that the primary tool for the Fed going forward was monetary policy. This was good news for anyone worried about the Fed dumping securities onto the market, and served to underpin US Treasuries. For those concerned about the Fed being too hawkish, the constant shrinking of $50bn a month may well have been another worry.
Powell said he was not worried about recent market volatility, nor the level of Treasury yields, as this was just a case of market behaviour during a risk off phase. However, he did acknowledge there had been a tightening of financial conditions as a consequence. We would agree, as recent credit spread widening has been significant and have probably had the equivalent effect of another rate hike.
On the tightening of financial conditions, Powell commented that the Fed was going to review introducing a countercyclical buffer for the banks in the coming months, but made it clear no decision had been made. If introduced this would be another source of tightening and consistent with an ageing cycle.
All told, the market does not share the Fed’s same rosy outlook for the economy, and the market is worried the Fed may be making a mistake by tightening conditions too far and too quickly. Looking at the market’s reaction overnight and reflecting on the last couple of months, we think investors are broadly carrying too much risk into what they think may be a slowdown; they have been dumping risk assets, and simultaneously buying more ‘risk-free’ assets such as US Treasuries.
We expect this trend to continue, sending Treasury yields lower still in the months ahead. We also think it likely that the Fed will wind in its forecast for two further hikes in 2019, as the reality of a less rosy economic picture emerges and the other sources of tightening have an impact alongside the nine hikes already conducted in this ageing cycle.