Backdrop
Last night’s Fed meeting was higher stakes in the eyes of markets. On one hand, as the vaccination campaign is progressing in the US and more fiscal stimulus keeps on flowing into the economy, US growth prospects continue to improve. Economists now expect 5.6% real GDP growth in 2021, while the Fed in January had set its expectations at 4.2%. Second, the inflation outlook has also changed. On the core inflation side, not much has happened (+1.3% in February) but headline CPI has moved from 1.4% to 1.7% recently. The Cleveland Fed PCE nowcasting indicator has moved from 0.5% in March 2020 to 2.4% today, mirroring the trajectory of our own Inflation Nowcaster and Newscaster. Inflation risk has not been so high for 24 months. Thus, the central question ahead of the meeting was: will the Fed acknowledge the fact that the macro backdrop has significantly improved or will it pledge itself towards keeping rates as low as possible – similar rhetoric to the last ECB press conference? We suspected a bit of both. The macro improvement cannot be ignored and the recovery is too young for a drastic change of tone.
The Fed confirmed this expectation, revising its growth forecast for 2021 up from 4.2% to 6.5%, and for 2022, up from 3.2% to 3.3%. Their PCE forecasts were also revised upward, but not as much as the growth forecasts. Their inflation measure was expected to hit 1.8% in 2021 but is now expected to reach 2.4% by year-end. 2022 forecasts were also revised up, from 1.9% to 2.0%. These numbers align well with our own forecasts, even though the temporary nature of the Fed’s revised forecast can be questioned, especially with regards to inflation. Still, we see a statement in this revision: Fed officials are acknowledging the macro improvement, and it shows in their “dots”. Accounting for the additional vote, the Fed now sees itself raising rates tepidly in 2023. The wording around its action has also marginally evolved, reflecting the better environment: “the pace of the recovery in economic activity and employment has moderated in recent months” has become: “indicators of economic activity and employment have turned up recently”. Having said that, the Fed has made it clear that it sees the improvement that all investors are seeing and responding to. However, no mention has been made of the danger of rising rates or uncontrolled inflation. The rise in inflation is “transient”, that in our view is the keyword of this meeting. As long as the Fed does not see a longer-lasting growth acceleration, it will not believe in a longer-lasting inflation wave. When asked about a potential tapering, the answer was clear: “not now”. Goldilocks here we come.
Market Impact
Markets have been served with better growth, controlled inflation expectations and no changes to accommodation for the foreseeable future. The initial reaction weighed on the US dollar, pushed equities 1% higher than their intraday lows while yields on 10-year Treasuries were a touch softer.
The S&P 500 is back to historical highs of 3,960, 10-year yields are at 1.66% after reaching 1.685% earlier in the day (their highest level since February last year) while inflation breakevens continued to creep higher around the 2.3% level.
Broadly, investors seem to have found what they needed in this FOMC meeting: improvement in fundamentals and no early signs of tapering in liquidity injections.
Asset Allocation Consequences
Monetary and fiscal responses following the COVID-19 crisis have been unprecedented in size and scale. Between its forward guidance and its asset purchase programme, the Fed’s communication has been a boon for investors. Yesterday, with the improving macro conditions, exuberant sentiment and elevated valuations, the Fed showed no signs of concern for the current rise in long-term rates. With this in mind, our current dynamic assessment articulates around three dimensions:
Macro: Growth remains solid and inflation is on the rise. The longer-term picture is supportive for growth assets but also for inflation assets.
Market Sentiment: Sentiment is now very high for growth assets broadly, and this exuberance could lead to bursts of stress.
Valuation: Growth assets are expensive, while inflation assets have solidly repriced a reflation scenario.
From these three elements, our current dynamic allocation highlights that we should remain positive on growth and inflation-oriented assets, but these exposures have been reduced significantly reflecting the deteriorating risk/reward.
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