- Perceived patience at the Fed has played a major role in the recent stock market rally.
- The risk of a “Fed policy error” has likely declined considerably.
- Economic and inflationary conditions will still need to be watched closely.
A major catalyst in the stock market’s strong performance since the beginning of the year and its recovery since the depths of last December has been a shift in perspective at the Federal Reserve. Viewed just a few months ago as out of touch with the economy and robotic in its policy planning, the Fed of 2019 is now believed to have taken a decidedly dovish turn, one that is being perceived by the market as more patient in its demeanor and more sensitive to market conditions. When taking this into account, these past few months probably rank as one of the great Fed pivots in recent memory.
It was just a few short months ago that the market seemed to view the Fed as implementing rigid monetary policy with no concern to market impact. That interpretation contributed to a fierce selloff in stocks and widening of credit spreads between early October and late December. In fast forwarding to current market conditions, it now appears investors are convinced we have a more patient Fed, one that is more prone to wait out at least the first half of the year before raising rates as well as being more sensitive to market volatility. Were all of that not enough, it also now appears as though the Fed may slow the pace of its balance sheet reduction, a topic that also contributed to market volatility in the immediate aftermath of its December meeting. All of this has been perceived favorably by the market, at least in the short term.
While we believe this perception of a Mr.-Hyde-to-Dr.-Jekyll transition at the Fed is perhaps a bit too simplistic, we would agree that the market selloff of 4Q18 likely left Fed Chairman Jay Powell and his fellow Federal Open Market Committee (FOMC) members with enough battle scars to alter their initial policy plans. Recently released minutes from the Fed’s January meeting seem to support this notion, as seen in four major areas of the Fed’s discussions.
- The FOMC recognized that prospects of economic growth in the U.S., while still positive, have weakened and inflationary trends have softened. Both of these observations support continued patience on future rate hikes.
- The minutes also included the wording, “a patient and flexible approach was appropriate at this time as a way to manage risks while assessing incoming information.” This language also seemed consistent with the market’s interpretation of the Fed being on hold in regard to hiking rates for the imminent future.
- In general, the minutes also reported more and lengthier discussions about the Fed’s recent impact on the markets themselves, mostly pertaining to stocks and corporate bonds. We believe this helps the market to recognize the Jay Powell Fed to be not quite as market unfriendly as some thought during the final weeks of last year.
- Based on the minutes, there also now appears to be a strong probability the Fed will materially slow the pace of its balance sheet reduction, which until recently seemed to be on track to continue its roll off of $50 billion of bonds per month. That schedule had implied an overall decline from its current ownership of about $3.8 trillion in Treasury and mortgage bonds to about $2 trillion by the end of 2021. It now looks as though the Fed might well curtail this activity by the end of this year, perhaps stopping somewhere around $3.5 trillion. The takeaway here being that such a pullback would put less pressure on market rates and also serve as a signal that the Fed is adjusting its previous mechanically oriented view of the balance sheet to one more sensitive to economic growth expectations and market conditions.
All of this ties into the concept that the risk of a Fed policy error — that of raising interest rates into a slowing economy, something markets were gravely concerned about during the final months of last year — has declined considerably. This sense of relief, in our opinion, has played a key role in the market’s recent rally.
However, while the markets have certainly seemed somewhat giddy about the shift in perspective at the Fed and the slowing rate hike expectations that appear to come with it, we would still exercise caution in coming to the conclusion that the “all-clear” signal has been given by Chairman Powell and his fellow committee members. While we believe a first half pause on future rate hikes is the prudent decision at this point, we would not count out potential rate increases in the second half of the year or into 2020 in the event economic growth picks up, inflation rises, or the yield curve widens. At the current time, all of these factors seem benign from a rate perspective. However, as we have witnessed in recent months, tides can turn quickly and we believe this is still a Fed ready to act when it believes tightening is necessary. Market optimism based purely on the notion that we have a new and improved Federal Reserve watching the market’s back is in our opinion overly simplistic and should likely be tempered.
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