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Fed Surprises Market with Easier Policy Stance

By Kathy A Jones
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.

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