The Fed is on a roll. Just when we thought the Federal Open Market Committee (FOMC) couldn’t surprise markets with any more dovish (easy monetary policy) announcements, it did just that.
Following its two-day policy meeting last week, the FOMC announced on Wednesday the expectation for no additional rate hikes in 2019 (after expecting two hikes as recently as December) and only one 25 basis point increase next year. In addition, the FOMC announced an earlier than expected end to its balance sheet reduction process.
Both stock and bond markets reacted positively to the news on Wednesday and Thursday. Stocks because the Fed put is back, meaning that the Fed will do everything in its power to keep the current expansion in both the economy and financial markets going strong. Bonds because less monetary policy tightening is generally good for valuations, especially when inflation is under control.
Friday was a different story, however. On the back of weak economic data out of Europe, we saw a classic “risk-off” day. Stocks fell, corporate credit spreads widened and TIPS breakevens (a measure of inflation expectations) declined. Long-term U.S. Treasuries rallied and took certain yield curves into inversion territory, which historically has been a signal of a pending recession.
It now appears to us that financial markets have discounted much of the Fed’s dovishness. And with the Fed on-hold for further monetary policy announcements, moves in risk assets are likely to be driven mainly by how the economy evolves. Will the recent weakness in overseas economies, namely Europe and China, be transitory or more long-lasting, and will it bleed over into the U.S. economy, are the key questions moving forward. Any substantial change in inflation or inflation expectations will also be important to monitor.
High quality bonds such as tax-exempt municipals, U.S. Treasuries and highly rated corporate bonds have performed well, and will continue to encounter favorable conditions moving forward. The jury is still out for riskier assets such as lower rated corporates, however. Given the current environment, we think it’s prudent to position our strategies with a conservative bent, and remain patient to see how the situation evolves.
Source: Federal Reserve