The Fed could still hike rates again this year. Here's why.
As expected, the U.S. Federal Reserve (the Fed) left interest rates unchanged at the conclusion of today’s policy meeting, once again emphasising a patient approach to monetary policy in the months ahead.
No one should be surprised by this. After all, following Chair Jerome Powell’s pivotal speech on the 4th of January, every Federal Open Market Committee (FOMC) participant has advocated for a pause in the tightening cycle. The January FOMC meeting confirmed this dovish shift, and March’s meeting, which wrapped up today, simply quantified what we already knew — with an update to the dot-plot projections for the federal funds rate.
Unsurprisingly, the dot plot moved down today, with the median FOMC participant now expecting no rate hikes this year. It’s important to note, however, that this is not a commitment to keep rates on hold in 2019. And it is definitely not a commitment to keep rates on hold forever.
While market pricing reflects the latter — and even the probability of a rate cut — we view the balance of risks as still being skewed towards a hike. The precise timing of that next hike is highly uncertain, but our baseline calls for an increase in December. This differentiated forecast is a key component for why we expect Treasury yields to rise over the course of 2019.
Let’s review the evidence. The Fed paused its tightening cycle in early January for three key reasons:
- 1. Financial markets were very weak in the fourth quarter of 2018.
The associated tightening of financial conditions and the possibility that markets were sniffing out downside risks not yet apparent in the economic data were cause for caution at the Fed.
- 2. The global economy slowed into the end of 2018, with some tentative evidence that the U.S. economy was becoming infected by this weakness as well.
The global purchasing managers index for the manufacturing sector has steadily slowed since the end of 2017, and as of February 2019, stands only a whisker above the critical 50 threshold that delineates expanding and contracting activity levels.
Arguably the more important development for the Fed was tentative evidence in late December of a sharp slowing in the U.S. manufacturing sector, as indicated by the regional Fed manufacturing surveys and the new orders data within the Institute for Supply Management’s manufacturing survey. Measures of consumer and business confidence were also falling sharply at the turn of the year.
- 3. Inflationary pressures were muted.
This was arguably the biggest and most important shift in the Fed’s reaction function. Previously, the Fed was satisfied to hike interest rates on an expectation that a tight labour market would push inflation gradually higher over time. Now, Powell has put a flag in the sand, mandating that the actual inflation numbers move up and threaten the Fed’s symmetric 2% inflation target before taking monetary policy restrictive. Put differently, Powell now wants to see the whites of inflation’s eyes.
In the ten weeks since Powell’s big pivot, some of these risk factors have dissipated and others very much remain front and center for a cautious Fed.
- 1. Risk markets have recovered sharply, and broader financial conditions currently are arguably more favorable than when the Fed decided to hike last December.
This consideration is no longer a reason for the Fed to be on hold.
- 2. U.S. and global economic data remains mixed.
We would argue that downside risks have actually dissipated, and that there are some green shoots pointing to a potential re-acceleration in the global cycle. We are particularly encouraged by incremental moves from Chinese authorities to deliver more fiscal stimulus that looks likely to stabilise growth rates in China and across emerging markets, President Trump’s newfound optimism about a trade deal, and by some tentative evidence of a rebound in the industrial production data for Europe. We see tentative evidence that U.S. consumer and business confidence levels are recovering as well. The Fed can afford to wait for more evidence of these green shoots in the hard data.
- 3. Inflationary pressures remain muted and, if anything, have moderated further since Powell’s pivot.
Our translation of the recent consumer and producer price data suggests core PCE (personal consumption expenditures) inflation likely slipped to 1.8% in February. With inflation moving further away from the Fed’s 2% target at a time when Powell has effectively mandated that inflation needs to threaten 2% to warrant a hike, this is clearly dovish. Last week we pushed out our forecast on the likeliest timing of the next rate hike from September to December on this news. And Powell said today that he did not think the Fed had yet achieved its price stability mandate in a convincing way. In our view, the inflation data is the biggest watch point in terms of the hike vs. no hike decision going forward.
We suspect the Fed will be willing to keep rates on hold, even during the early phase of a global growth re-acceleration. That accommodation is an important tailwind for markets. The challenge for markets from here is that most of this positivity is already in the price. As noted earlier, Fed fund futures embed a view that the next move from the Fed is likely to be a rate cut. We think this is an overly pessimistic interpretation of current conditions. Why?
The Fed rarely cuts rates outside of economic recessions — which are obviously bad outcomes for equity markets. One recent exception to this rule was in late 1998. Following the Asian Financial Crisis and the implosion of long-term capital management, the Fed faced a recession 'scare' and cut rates by 75 basis points.1 At the time, the international backdrop was in crisis and core PCE inflation was subdued at around 1.2%, so a cut was very appropriate from a risk management perspective. We’re not there yet. We believe that the hurdle for a rate cut is high, and neither we nor, it appears, Jerome Powell, see it in the data right now.
If our view is correct, the future path for Treasury yields is more likely to be higher from here. While government bonds may offer very important diversification benefits in multi-asset portfolios as we get later in the business cycle, our tactical preference is to keep interest-rate sensitivity below normal levels right now.
1 Source: https://www.bloomberg.com/opinion/articles/2019-01-10/how-the-fed-can-engineer-a-soft-landing
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