As was widely expected by the market (0% probability embedded in the Fed Funds futures market), the FOMC unanimously elected to leave the benchmark rate (2.25-2.50%) unchanged at today’s FOMC meeting.
While risk asset volatility has declined significantly and as equities (as measured by the S&P 500) have posted the best start to a year since the early 1990s, the FOMC decision to leave rates unchanged came amidst slowing global growth concerns given continued trade uncertainty and as price pressures (seen through both inflation and inflation expectations) have fallen to multi-year lows.
Outside of the interest rate discussion, below are some of the key highlights from the FOMC meeting as the Fed struck a more “dovish” tone than market consensus.
No 2019 Fed Rate Hikes – As inflation remains subdued around or below the Fed’s symmetric inflation target and as global growth has slowed, the FOMC reaffirmed its “patience” regarding further tightening in monetary policy. With respect to future rate hikes, in a more “dovish” measure, the Fed lowered its 2019 (to 2.4% from 2.9%), 2020 (to 2.6% from 3.1%) and 2021 (to 2.6% from 3.1%) median Fed Funds forecasts from its most recent December FOMC meeting rate hike forecasts. This suggests that the Fed expects to leave rates unchanged throughout 2019 (down from the previous forecast of two rate hikes), hike once in 2020 (consistent with the previous forecast) and then remain on hold through 2021. With respect to the longer run, the Fed left the longer term neutral rate unchanged at 2.8%. This suggests that the Fed will leave rates below the median neutral rate (2.8%) and in an “accommodative” stance through 2021 at least.
Slowdown from “Solid” Growth – Consistent with slowing global economic growth, the Fed acknowledged that domestic economic activity has slowed from the “solid” rate seen throughout 2018 as “recent indicators point to slower growth of household and business fixed investment in the first quarter”. However, the Fed highlighted that it continues to view “sustained expansion of economic activity and strong labor market conditions” as the most likely trajectory for the economy and Jerome Powell highlighted that the U.S. economy remains “in a good place”. The Fed downgraded its 2019 (from +2.3% to +2.1%) and 2020 (from +2.0% to +1.9%) economic growth forecasts while leaving its 2020 (+1.8%) and longer term growth rate (+1.9%) forecasts unchanged. This suggest that, despite the downgrade to its 2019 economic growth forecast, the Fed still expects economic growth to remain above the longer term trend throughout 2019.
Conclusion of Quantitative Tightening – In a separately released statement following the meeting, the Fed announced that it would begin to taper its balance sheet run off process (quantitative tightening) by reducing the cap on monthly redemptions (from the current level $30 to $15 billion) starting in May. After this, the Fed will conclude the reduction of its balance sheet at the end of September 2019. Jerome Powell highlighted in his press conference that he expects the concluding level of the balance sheet following the run off process to be ~$3.5 trillion.
Given the more dovish actions by the Fed to reduce expectations for future Fed rate hikes and end the balance sheet run off process, risk assets rallied following the FOMC meeting and press conference. As a result, the S&P 500 extended its best start to a year since 1991 and rallied (+0.1%) to the highest level since October 2018 after being down 0.5% heading into the meeting. Treasury yields declined on the lowered expectations for future economic growth and rate hikes as the 10YR Treasury yield declined (-8 bps to +2.53%) to the lowest level since January 2018. The dollar (DXY: -0.5%) declined while gold (+0.5%) on the reduced expectations for future Fed rate hikes.
With respect to future rate hikes, the futures market continues to show a 0% chance of a rate hike through year end 2019, while expectations for a rate cut over that time period (38% versus 25%) increased from prior to the meeting.
Outlook — The Fed still has room to hike
The FOMC meeting was within our expectation that the Fed will continue to remain patient with respect to the further tightening of monetary policy. Despite the downgrade to 2019 and 2020 GDP forecasts, the Fed’s above trend economic growth forecast through 2019 and constructive view on the economy is consistent with the elevated levels we have seen in both confidence (consumer and business confidence well above historical averages) and manufacturing (ISM manufacturing remains solidly in expansionary territory). In addition, the expectation for a continued tightening in the labor market should further support consumer spending going forward. With limited risk of recession on the horizon, solid economic fundamentals should allow for a further normalization in monetary policy via a modest increase in interest rates.
While the futures market continues to reflect a greater probability of a rate cut (38%) relative to a rate hike (0%) through year-end, we continue to believe that the underlying strength of the U.S. economy will push the Fed to raise rates one additional time over the next 12 months. This further Fed tightening, in combination with our expectation for above trend growth (2019 GDP forecast: +2.3%) in 2019 should push longer term interest rates higher over the next 12 months. Despite long-term sovereign yields remaining stubbornly low over recent months, we expect the 10 YR Treasury yield to rise to 3.00% by March 2020. With respect to equity markets, while volatility will likely remain elevated as a result of trade concerns and slowing global economic growth, we expect equities will move slight higher over the next 12 months (March 2020 S&P 500 target – 2,850) as a result of still solid domestic economic fundamentals and positive (albeit slower) earnings growth.
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