Taking into account US economic conditions of full unemployment and inflation close to target, the reiteration in yesterday’s FOMC statement of the policy of gradually returning US rates to neutral levels is understandable. Furthermore, lowering the rate trajectory for 2019 from 3 to 2 projected rate hikes also makes sense given the tightening of financial conditions (namely falling equity prices and rising credit spreads) since the summer. However, we believe markets were looking for something stronger than ‘wait and see’ to counter the negative psychology which has led to a very poor December for global equity markets.
However, for a central bank which wishes to reach sufficiently high policy rates to allow for a suitably large interest rate response in the event of an economic downturn, we believe a ‘free’ opportunity to reassure markets was missed during the press conference yesterday. As a result markets have reacted poorly overnight to the FOMC decision.
There is sufficient growth uncertainty in the global economy, especially in terms of the soft data which indicates a slowdown in China and Europe, to create a possibility of a confidence-led drop in activity which might have been avoidable had Fed Chair Powell’s comments suggested a more resolute focus on the risks to global growth.
In addition, the problem of economic divergence between the US and Europe risks reasserting the “our dollar, your problem dynamic”, unless the US Fed pays greater attention to overseas developments. UK and eurozone economic survey data has moved sharply lower in recent weeks, unlike the US where we would agree with the FOMC’s assessment that growth is at present strong.
We believe the debate over the “autopilot” reduction of the Fed’s balance sheet is a distractor as there is limited evidence yet of quantitative tightening impacting long-term rates. In fact, 10y rates have been shrinking since the summer from 3.25% to 2.78% as growth forecasts are revised lower. Previously we have written about the likelihood of increased net issuance, due to the combination of the reduction of the Fed’s balance sheet and the large US fiscal deficit, putting upward pressure on US bond yields but there is no evidence of this pressure at this stage.
The relative lack of concern of the Fed to the current level of asset prices suggests that the ‘Fed put’ remains some way out of the money. With rates described by Powell as at the lower end of the neutral range and future decisions data dependent, there is certainly scope for a pause in rate increases in Q1 19. However, we believe markets were looking for something stronger than ‘wait and see’ to counter the negative psychology which has led to a very poor December for global equity markets.