At its January meeting, the Federal Reserve kept its policy rate unchanged, as widely expected, but adopted a broadly more dovish stance than its December meeting.  The Fed has removed references to rate hikes from the statement and issued a new statement on the balance sheet reduction, indicating it will be flexible in the unwind of quantitative easing.  The meeting echoed Jerome Powell’s ‘patient and flexible’ tone in early January at a speech in Atlanta.

We now see the possibility of the Fed hiking rates once or maybe twice in the second half of the year, but only if the downside risks to growth do not materialise.  As such, concerns about growth could prevent the Fed from hiking.  The new statement on balance sheet reduction addressed both the overall size of the balance sheet as well as the pace at which it will be reduced.  We believe the new statement steered the Fed away from its previous, “auto-pilot” pace of reduction, and also prepared the market for less of an overall reduction than anticipated. Chairman Powell clarified that the FOMC will continue to use the fed funds rate as its primary tool to conduct monetary policy, with balance sheet adjustment as a secondary tool when required.

On rates: The FOMC notably changed the description of its policy stance from the December meeting, 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 contrasts with the December meeting when the FOMC said that ‘some further gradual increases’ in the Fed fund rate would be required. 

On the balance sheet: The FOMC provided further clarity on its balance sheet reduction.  It suggested that the overall size of the balance sheet would be larger than before the 2008 financial crisis – this means a balance sheet that is larger than previously expected when the Fed was unwinding purchases.  The Fed also introduced flexibility in the pace of the normalisation in what was a marked move away from its previous ‘auto-pilot’ attitude towards reductions.  Now, the Fed has said the reduction will depend on economic conditions, opening the door to a slower pace.

At the press conference, Chairman Powell justified the Fed’s stance by saying that, while the outlook for the US economy remains solid, the global economy has slowed, financial conditions have tightened and the outlook has faced many crosscurrents, ranging from political uncertainty to trade policy uncertainty.  These concerns echo a slowdown in growth in the Eurozone which have pushed the European Central Bank into assessment mode and prompted genuine concern. 
 
Overall, we believe that the FOMC delivered a message that was at the dovish end of expectations by indicating that the current level of interest rates was judged appropriate, and by communicating some flexibility on the balance sheet adjustment. The FOMC has also 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 signalling by the Federal Reserve will be to clarify the optimal size of the balance sheet, whether a slower pace of normalisation may be required, and the Fed’s optimal maturity composition. 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.  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.

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