Download the Schwab app from iTunes®Get the AppClose

Fed Surprises Market with Easier Policy Stance

Key Points
  • As expected, the Federal Reserve left interest rates unchanged at its March policymaking meeting, but surprised markets with a shift to an easier policy stance.

  • The Fed’s “dot plot” indicates there will be no more rate hikes this year.

  • Economic and inflation projections were lowered.

  • The Fed plans to end its balance sheet reduction soon.

As expected, the Federal Reserve kept its benchmark short-term interest rate steady at its March meeting, leaving the federal funds rate¹ target range at 2.25% to 2.5%. That was not a surprise, as Federal Reserve Chair Jerome Powell had already indicated that the Fed planned to be “patient” about changing policy. However, the Fed surprised markets by indicating that policy for the remainder of the year will be even easier than had been expected.

Dots dipping lower

The Fed’s “dot plot,” a chart that shows where each member of the Federal Open Market Committee (FOMC) believes the federal funds rate target should be at the end of coming years, indicated that the rate will remain unchanged this year and only increase once next year, bringing the federal funds rate to a 2.5% to 2.75% range at the peak of this cycle. That’s down from previous estimates of two rate hikes this year and another down the road. It was a far more “dovish” take on the outlook for policy than expected.

The latest dot plot indicates policymakers expect no rate hike in 2019

Source: Federal Reserve, as of 03/20/2019.

Notes: The FOMC Dots Median reflects policymakers’ expectations for interest rates. The fed funds futures rate is what investors expect the fed funds rate to be in the future. The overnight index swap (OIS) is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index, such as the overnight federal funds rate, as the underlying rate for its floating leg, while the fixed leg would be set at an assumed rate.

We have doubted the Fed’s ability to push up interest rates any further. Global central banks are taking steps to ease monetary policy in response to a sharp slowdown in growth, the domestic economy is cooling off and inflation hasn’t been at the Fed’s 2% target for years. It seemed unlikely to us that the Fed would want to continue tightening monetary policy in this environment, as it would risk pushing the value of the dollar up and slowing the economy even more than it already is.

Growth projected to slow gradually

In fact, the updated summary of economic projections indicates that the Fed has downgraded its assessment of the economy’s growth rate over the next few years. U.S. gross domestic product (GDP) growth estimates were reduced for 2019 to 2.1%from the previous estimate of 2.3%. Similar reductions were made for 2020. The unemployment rate estimate was projected to move to 3.7% in 2019 compared to the previous estimate of 3.5% at the December meeting.

The Fed has reduced its projections for economic growth

Source: Federal Reserve, as of 3/20/2019.

Notes: For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. Longer-run projections for core PCE inflation are not collected.

Inflation expectations were also lowered. The Fed’s median estimate is now for inflation to average 1.8% in 2019, and 1.9%% in 2020 and 2021 respectively, which is below its 2% target. To a large extent the changes made by the Fed have simply reflected the market’s current view of growth and inflation. The Fed has been forecasting higher inflation for several years, while market expectations have been trending lower. In the Treasury Inflation-Protected Securities (TIPS) market, breakeven rates fell sharply at the end of 2018 for five and 10-year bonds, and despite a modest rebound lately, remain below the Fed’s 2% target. Survey-based readings, such as the “expected changes in prices” element of the University of Michigan’s Survey of Consumers, also show a downward trend in inflation expectations.

Five-year and 10-year TIPS breakeven rates


Source: Bloomberg.  U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index).  Monthly data as of March 20, 2019.

One-year inflation expectations far below the long-term average of 2.7%

Source: Bloomberg. University of Michigan Consumer Survey: Expected Change in Prices During the Next Year: Median Index. Monthly data as of March 2019.

Balance sheet to stay large

The biggest surprise in the Fed announcement was its decision to end its balance sheet reduction in September of this year. In recent comments, Fed officials have indicated that the reduction in the balance sheet will likely end later this year with total assets near $3.5 trillion or about 17% of GDP, much higher than previously indicated. The Fed is also reducing the cap that it has placed on the dollar value of the U.S. Treasuries it allows to mature each month from $30 billion to $15 billion in May.

The size of the balance sheet is of interest to the market because a large balance sheet relative to the size of the economy is seen as a way to ease monetary policy. In the aftermath of the financial crisis, the Fed bought Treasury bonds and mortgage-backed securities (MBS) in an effort to hold down long-term interest rates and stimulate risk-taking. The idea was that if money were cheap and available, consumers and investors would spend and invest and thereby boost economic growth.

The size of the Fed’s balance sheet ballooned after the financial crisis


Source: Federal Reserve Bank of New York and the Board of Governors of the Federal Reserve, using data as of 1/2/2019.

The Fed engaged in three rounds of bond buying between 2008 and 2014—a practice known as “quantitative easing, or QE—expanding its balance sheet to $4.5 trillion by 2014, or about 25% of GDP, from about $800 billion, or about 6% of GDP, in 2008. There is a lot of debate about whether and how QE worked. Economists have estimated that it reduced 10-year Treasury yields by about 1% (estimates range from 0.5% to 1.5 %).

In 2017, the Fed began the process of allowing the balance sheet to shrink as bonds matured. The plan was communicated well in advance and was meant to be a slow process that didn’t disrupt markets. Former Fed Chair Janet Yellen described it as “watching paint dry.” Although there were fears that allowing the balance sheet to shrink would send interest rates higher, that hasn’t been the case. Bond yields haven’t moved that much since the balance sheet runoff began, despite nine rate hikes by the Fed since late 2015.

Concerns about a shortage of reserves in the banking system are the driver behind the Fed’s decision to maintain a larger balance sheet. Regulatory changes since the financial crisis require banks to hold more safe capital that can be deployed if there is a sharp downturn in the economy. The intent is to prevent another bailout of banks by taxpayers. Consequently, demand for reserves—which are considered safe capital—has been quite a bit higher than the Fed anticipated a few years ago. A level of about $1 trillion is likely to be consistent with what the financial sector requires.

The Federal Reserve’s total assets and bank excess reserves have declined


Source: Federal Reserve Bank of St. Louis. All Federal Reserve Banks: Total Assets (WALCL), and Excess Reserves of Depository Institutions (EXCSRESNS), Millions of Dollars, Monthly, Not Seasonally Adjusted.  Monthly data as of February 2019.

Also, the Fed would like to revert to a balance sheet that holds only Treasuries. However, zeroing out the MBS holdings by allowing bonds to mature could take many years. The slow pace at which MBS are rolling off the balance sheet reflects, to some degree, the sluggishness of turnover in the housing market, because mortgages aren’t being refinanced and retired as quickly as they would if the housing market were stronger. The Fed’s decision to keep the MBS and reinvest the maturing bonds and interest into treasuries suggests the shift to treasuries only will be slow and gradual.

A return to “normal” would mean a Treasuries-only balance sheet, and one that presumably held less long-term debt. Given the narrowing of the yield curve, the Fed might want to swap long-term bonds for shorter-term Treasury bills in order to steepen the curve. A steeper yield curve, would represent a return to a more normal configuration and reduce the risk that the curve would invert. Investors worry about an inverted yield curve because it is often seen as a recession indicator.

Key takeaways for bond investors:

1. Short-term interest rates may have peaked. The Fed is unlikely to raise the federal funds rate again this year in our view and there is some chance that the next move by the Fed could be a rate cut. For investors in floating-rate debt, it may make sense to move some funds into fixed rate investments.

2. Ten-year Treasury yields have most likely peaked for the cycle. We continue to believe that the 3.25% level reached late last year was a cycle peak. Investors may want to consider gradually adding intermediate-to-long-term bonds to their portfolios to lock in those yields. One potential strategy is to consider a “barbell,” holding short-term Treasury bills, bonds or certificates of deposit (CDs) on one side of the “barbell” and seven- to 10-year bonds on the other side.

3. Markets were already priced for good news. Credit spreads—the yield difference between Treasuries and corporate bonds—are low, reflecting diminishing concerns about an economic downturn. Long-term yields have fallen steeply and riskier segments of the market like emerging market and high yield bonds have posted strong gains. Consequently, we are tempering our expectations for return for the remainder of the year. We expect investors to earn the coupon income, but price gains going forward may be limited.

Year-to-date return for fixed income asset classes

Source: Bloomberg, as of 03/15/2019. Past performance is no guarantee of future results. Asset classes are represented by the following indexes: US Aggregate = Bloomberg Barclays U.S. Aggregate Bond Total Return Index; Short-term core = Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index; Intermediate-term core = Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index; Long-term core = Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index; Treasuries = Bloomberg Barclays U.S. Treasury Index; TIPS = Bloomberg Barclays U.S. Treasury TIPS Total Return Index; Agencies = Bloomberg Barclays U.S. Agency Bond Total Return Index; Securitized = Bloomberg Barclays U.S. Securitized Bond Total Return Index; Municipals = Bloomberg Barclays Municipal Bond Total Return Index; IG Corporates = Bloomberg Barclays Corporate Bond Total Return Index; HY Corporates = Bloomberg Barclays U.S. High Yield VLI Total Return Index; IG floaters = Bloomberg Barclays US Floating Rate Notes Total Return Index; Bank loans = The S&P/LSTA U.S. Leveraged Loan 100 Index; Preferreds = Merrill Lynch BofA Preferred Stock Total Return Index; Int. developed (x-USD) = Bloomberg Barclays Int'l Developed Bonds (x-USD) Total Return Index; EM = Bloomberg Barclays Emerging Market Bond (USD) Total Return Index.


¹ The federal funds rate is the interest rate at which depository institutions, such as banks and credit unions, lend reserves overnight to other depository institutions.

What You Can Do Next

  • Follow Kathy Jones (@KathyJones) on Twitter.
  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
Funding Your Retirement
Planning Your Retirement Income Distribution
Have You Taken Care of Your Estate Planning Basics?

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more. The 1-3 year, 5-7 year, and 10+ year indexes are all components of the broad U.S. Aggregate Bond Index.

The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Bloomberg Barclays U.S. Agency Bond Index includes securities issued by US government owned or government sponsored entities, and debt explicitly guaranteed by the US government). It is a component of the Bloomberg Barclays U.S. Government Bond Index.

The Bloomberg Barclays U.S. Securitized Bond Total Return Index is part of the broad Bloomberg Barclays U.S. Aggregate Bond Index and is designed to capture fixed income instruments whose payments are backed or directly derived from a pool of assets that is protected or ring-fenced from the credit of a particular issuer (either by bankruptcy remote special purpose vehicle or bond covenant). Underlying collateral for securitized bonds can include residential mortgages, commercial mortgages, public sector loans, auto loans or credit card payments. There are four main subcomponents of the securitized sector: MBS Pass-Through, ABS, CMBS and Covered.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. High-Yield Very Liquid (VLI) Index measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. The U.S. Corporate High-Yield Index was created in 1986, with history backfilled to July 1, 1983, and rolls up into the Barclays U.S. Universal and Global High-Yield Indices.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

The S&P/LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. The index consists of 100 loan facilities drawn from a larger benchmark - the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).

The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays Global Aggregate ex USD Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.