In its first meeting since the post-December FOMC meeting market correction, the Federal Reserve kept its policy rate unchanged, as widely expected.
However, the FOMC made a notable change describing its policy stance, saying ‘ the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes’. This is a reversal compared to the December meeting when the FOMC said that ‘some further gradual increases’ in the Fed funds rate would be required.
In addition, the FOMC also provided more clarity on its balance sheet adjustment, meaning that its size would be larger than pre-financial crisis and also introducing some flexibility in the pace of normalization. At the press conference, Chairman Powell justified the Fed’s stance by the fact that, while the outlook for the US economy remains solid, the global economy has slowed, financial conditions have tightened and there are many crosscurrents to the outlook, ranging from political uncertainty to trade policy uncertainty.
Overall, we believe that the FOMC delivered a message that was at the dovish end of the spectrum of expectations by signaling that the current level of interest rates was judged as appropriate, and by signalling some flexibility on the balance sheet adjustment.
In our view, the Federal Reserve will keep its policy rates on hold for at least the first half of 2019. But, given the tightness of the labour market and the continued acceleration in wage growth, the Fed could hike rates once or maybe twice in the second half of the year if the downside risks to growth do not materialise. As such, the FOMC has shown that it is sensitive to the performance of the equity market, and a further rally would likely put a rate hike back on the table. We believe that the next policy move by the Federal Reserve will be to clarify the optimal size of the balance sheet, whether a slower pace of convergence may be required, and what will be the optimal composition of the Fed’s portfolio in terms of maturity. A decision on those aspects is likely in the coming months.
Investment implications: With the Federal Reserve on a cautious path, monetary conditions are unlikely to tighten sharply and meaningfully in the coming months, unless a negative shock hits the economy, and the USD should depreciate somewhat. As such, we see a low likelihood of a US recession this year, in line with our Global Outlook for 2019 (link here). This means that investors should remain cautiously optimistic on risky assets, and that the current relative outperformance of emerging market assets should continue. On the fixed income side, the level of US rates and their limited upside remain attractive, especially given the heightened uncertainty and weaker global growth outlook. In this asset class, we believe investors should focus on quality issuers in corporate space.
Charles St Arnaud – Senior Investment Strategist – Lombard Odier IM