No More ‘Patience’

Yesterday, the Fed took a step in the direction of market expectations, as reflected in recent pricing. The odds for monetary policy easing through rate cuts and balance sheet expansion surged dramatically. The “patience” rhetoric was removed from the statement and the Committee is pointing towards dovishness.

The Fed’s ‘dot plot’, which illustrates Board members’ rate level expectations, materially evolved on the dovish side. For 2019, even though the median rate remains at current levels, the number of voters favouring a cut is about half, depicting a much more divided assembly than before, and a tilt towards a cut before year end. Projections in 2020 have been reduced by two notches, from a hike to a cut. During the press conference, there was a clear indication that the combination of strong cross currents and increasing concerns around undershooting inflation should warrant more accommodation from the Fed.

Indeed, Jerome Powell acknowledged external risks to economic expansion as a major cloud on the horizon. However, economic growth forecasts have been kept unchanged, while inflation expectations were revised downward. Respectively, GDP growth forecasts are now 2.1% in 2019 and 2% in 2020, while PCE inflation rate is expected to fall to 1.5% in 2019 and 1.9% in 2020, from 1.8% and 2% previously.

This confirms the increasingly dovish tone that various Fed members have been adopting since the beginning of the year and echoes the stances of all other major central banks. Yesterday, Draghi referred to the potential for additional easing by the ECB, which triggered a strong rally in both equities and bonds.

Market Impact

The pricing of a dovish statement was extremely high ahead of the FOMC meeting, and market responses reflected a mixed message, with dots and macro projections not completely aligned. Immediately after the announcement, 10-year yields retreated while stocks were stable. The S&P was hovering around 2920, while the 2-year yield was 10bps lower at 1.78%. The US dollar index was trading 0.40% lower.

Asset Allocation Consequences

The U-turn that started late last year is now almost complete. Central banks have moved from a coordinated tightening stance in mid-2018 to a synchronised accommodative one in a bid to avoid the transformation of the current macroeconomic deceleration into the next recession. The combination of the dots and economic forecasts highlights what we have recently stated: that the current scenario is more comparable to the 1995 situation when the Fed took a pre-emptive approach, versus 2001 and 2007 and the economic contractions that followed.

Our current dynamic assessment revolves around three risk factors:

  • Macro Risk: Growth conditions, as depicted in our proprietary Nowcasters, have stabilised around potential but do not show signs of reacceleration yet. On the other hand, inflation remains subdued everywhere and continues to decline. This should warrant accommodation from central banks in the medium run, and benefit growth-oriented assets such as equities and credit.
  • Market Sentiment: Market stress is receding and the Fed has once again managed to reduce both macro and market volatility. Until signs of a marked economic slowdown toward recessionary levels appear, we see a strong potential for risk assets to thrive on the back of the current favourable context. However, given the pricing of central bank action, maintaining tactical hedges seems appropriate to cover the risk of escalating tensions on the trade war front.
  • Valuation: Even if asset pricing is not broadly expensive, we see pockets of expensiveness, especially in government bonds.

In aggregate, the current macro picture is supportive for risk taking, while sentiment and valuation call for selective cautiousness, especially in the bonds space.

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