As the Fed Cleans Up Its Language, the Markets Are Loving Every Word

06.24.2019 - Douglas Tommasone, CFA

When the Fed pushed the pause button in January, after raising rates nine times in three years, many assumed its next monetary policy move would be picking up where it left off in its tightening cycle.

Instead, a stubbornly sluggish global economy, hampered by an increasingly belligerent tone in US trade relations, led many market participants to expect the Fed to move in the opposite direction, hitting the rewind button and signaling the beginning an easing cycle instead. In fact, many have been clamoring for the Fed to cut rates as financial markets reflect the market’s near-consensus conviction that the Fed will ease several times by year end.

All told, this backdrop created the most uncertainty over monetary policy we have seen in quite some time and put Chairman Powell under immense pressure to deliver during the Fed’s June 20 meeting.

Powell Delivers a Clearer Message 

Although the Fed did not raise rates on June 20th, Powell calmed the markets by expressing the Fed’s increasingly dovish outlook. While the FOMC continues to believe the US economy is performing well, it acknowledged that threats to its outlook have recently increased. This subtle shift in tone eased market concerns about the Fed’s ability to successfully pivot from tightening to easing and reduced the uncertainty that escalated in March, when the Fed did not signal any shift in rates.

The press conference following the Fed’s June 20th meeting reinforced its dovishness, as Powell summed up the Fed’s thinking with the old adage: “An ounce of prevention is worth a pound of cure.” Market participants who have been advocating for an interest rate cut as “insurance” against an economic slowdown received a clear signal that the Fed is considering the appropriateness of such a move. Former Fed Chairman Alan Greenspan used similar language to alleviate market fears of a recession in the 1990s.

A New Focus on Preventing a Recession

The Fed’s primary goal today is preventing a recession, as evidenced by its shift away from additional interest rate hikes and toward easing. Another indication of the Fed’s evolving position is its expressed belief that the best way to prevent an economic downturn is to reduce rates quickly and deeply. Faster, more decisive action is the strongest tool the Fed has at its disposal.

In this respect, the Fed faces a serious challenge. Even after nine hikes, rates remain historically low. This makes it almost impossible for the Fed to cut rates sooner and more significantly than usual, barring the highly unlikely decision to follow the European Central Bank and move toward negative rates.

US economic data has become more mixed in 2019. First quarter GDP growth exceeded expectations but was largely driven by temporary factors that could prove to be a drag in coming quarters. While retail sales appear to have rebounded, May’s non-farm payroll report was disappointing . In addition to questionable economic data here in the US, the Fed is confronted with tariffs and trade tensions that have dampened global growth and eroded business confidence, as evidenced by weakness in corporate spending. The protracted nature of this overhang is an important factor in the Fed’s thinking, as Powell specifically cited traded developments and their impact on global growth as risks that have grown.

The only mention of persistently low inflation came late in Powell's press conference, which gave the impression that the Fed’s unsuccessful efforts to hit the 2% target were a secondary concern in its decision to pivot. Some of the negative conditions the Fed described as “transitory’” in March did rebound, but the Fed continued to undershoot its inflation projections. Furthermore, surveys that play a prominent role in the Fed’s inflation models have weakened.

The Fed recently indicated it is likely to fall short of its inflation target for another 18 months.

Markets Cheer the Fed’s Forward Guidance

Markets were delighted by what they heard from the Fed this month. Equity markets rallied on the Fed’s commitment to preventing a recession, allowing equity valuations to reflect the improved cost of capital from lower interest rates. Perhaps more surprisingly, bond prices remained near year to date highs despite yields having ground inexorably lower during the lead up to the meeting.

One offshoot of the Fed’s global perspective is that it is now likely to pay more attention to the strengthening dollar, an unintended consequence of tightening in the US while rates overseas remain anchored near or below zero. With an awareness of the global backdrop, the Fed seems less likely to exacerbate the issues caused by a stronger dollar and more likely to mirror the accommodative policy measures we have seen from the ECB and many other central banks.

The takeaway is that monetary policy could resynchronize globally, which has comforted equity investors while pushing US bond yields lower, in the direction of yields in global markets.

Under Pressure: Will the Fed Deliver in July?

The Fed’s next meeting is scheduled for July 30 and 31, and the pressure to match its words with action will be intense. The outcome of a Fed meeting is never certain, but many strategists are calling for a cut of 50 basis points, which would bring the fed funds rate down to 2%.

At the Fed, policymakers are hoping the G20 summit on June 28 and 29 will bring major improvements on the trade front. If that happens, however, the markets could rally, relieve the Fed of its newfound concerns about global challenges and end the pivot before it ever begins.

Regardless of what happens, the Fed is once again at the center of the market’s attention. Following a year of mechanical policy moves last year, 2019 has already made it clear that the Fed’s thinking has changed along with its approach to communicating with the public.

Written by Doug Tommasone, Senior Fixed Income Portfolio Manager.

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