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Fed policy and US economy, what’s next?

 

Investment Talks CB Assessing the Fed Dec 2018-Header-1
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  • US economy: We expect the US economy to grow above potential in 2019 and to gradually converge to its long-term growth rate of around 2% in 2020 as the boost provided by fiscal expansion in 2018 will gradually lose steam.
  • The path ahead for the Fed: With the economy running above potential and the labour market becoming tighter, the Fed may choose to continue normalising and hiking rates until signs of a deceleration in growth materialise. The Fed’s expectations regarding inflation are broadly aligned with our own forecasts (2.2% Amundi vs 2.3% Fed median), but risks remain tilted to the upside. In our view, the Fed will be more cautious than in 2018 and we expect a pause in the hiking cycle by mid-2019 at the latest. The Fed has also made clear that it will not change its strategy for shrinking the balance sheet: 
  • Financial conditions: The rise in credit spreads represents a de facto tightening of credit conditions that the Fed can no longer ignore. The amount of investment-grade BBB corporate bonds is at a record level. Should the economy experience a sharp slowdown, these bonds would be at risk of downgrade to high yield (HY), potentially causing forced sales and therefore a sudden tightening of all credit conditions. Hence, the Fed will have to monitor the ability of companies to absorb a further tightening of their financing conditions. We also think that the huge rise in US funding needs in a context of lower liquidity will likely continue to be satisfied by dollar investors and will contribute to a tightening in global financing conditions. Hence, we see the potential rise in long-term core government bond yield as very limited. 
  • Political interference: Although we see the Fed defending its independence, there is the risk that political interference could prove counterproductive.

The Fed will be more cautious than in 2018. We expect a pause in mid-2019 at the latest.

US growth is still sound, but wage pressures are building. Do you see a risk that the Fed could be behind the curve? What is your outlook for growth and inflation in 2019? 

We expect the US economy to grow above potential in 2019 and to gradually converge to its long-term growth rate of around 2% in 2020, as the boost provided by fiscal expansion in 2018 should gradually lose steam. As a result, domestic demand will gradually slow. With the economy running above potential and the labour market becoming tighter, the Fed may choose to continue normalising and keep raising rates until signs of a deceleration in growth materialises. Having said that, we expect the Fed to become much more cautious. Global growth is not as supportive as it was in early 2018. Monetary and financial conditions have tightened quite substantially over the past few months and this will impact growth with a lag of several months. The impact of fiscal policy is expected to vanish in 2019. Regarding inflation, the Fed’s expectations are broadly aligned with our own forecasts (2.2% Amundi vs 2.3% Fed median) as well as regarding inflation Core PCE (2.0%); while risks remain tilted to the upside, production bottlenecks, higher wage dynamics, and increased production costs from tariffs could weigh on companies, and some of the pressure could be transferred to consumer prices.

However, the Fed will be more cautious than in 2018. We expect a pause in mid-2019 at the latest. Credit conditions will be a key determining factor regarding the Fed’s monetary policy looking ahead. In 2018, the Fed looked to rebalance the policy mix (excessively expansionist at this stage of the cycle) and to regain some room for manoeuvre in terms of monetary policy. With less support from fiscal policy likely ahead, we expect the Fed to become more cautious.

 

For the Fed, it is not so much a debate about the level of the equilibrium rate (the measure of which is known to be very uncertain), but about the ability of companies to absorb a further tightening of their financing conditions.

Do you see the tightening of financing conditions as a concern for the Fed? 

From a macroeconomic standpoint, the US economy remains solid and calls for the Fed to continue raising rates. But, the rise in credit spreads represents a de facto tightening of credit conditions that the Fed can no longer ignore.

Indeed, outstanding bond debt has increased significantly during this cycle, especially over the recent period, for companies with low profits and high debt. The amount of risky debt now stands at over $2,300bn. At the same time, we note that investment-grade bonds (BBB) have reached record levels (35% of corporate bond debt). A sharp slowdown in the US economy would quickly shift some of these bonds into the HY category, causing forced sales of the latter and thereby a sudden tightening of all credit conditions. Against this backdrop, for the Fed, it is not so much a debate about the level of the equilibrium rate (the measure of which is known to be very uncertain), but about the ability of companies to absorb a further tightening of their financing conditions that does not weigh on their investment and therefore on growth prospects.

 

US Treasury auctions have seen steady demand, supported by US households, which is expected to persist in 2019 and to support bond yields.

What are the supply/demand dynamics driving the US Treasury market?

Jerome Powell was clear that the Fed won’t change its strategy for shrinking the balance sheet:

  • This is a key element for the fixed income market. The pace of the reduction of the Fed balance sheet is accelerating to about $500bn in 2019 (after $350bn in 2018). This is a big swing considering that until 2017, there was massive balance sheet expansion by the major central banks (Fed, ECB, BoJ). Total assets on the Federal Reserve’s balance sheet increased from $870bn on August 2007 to $4.5tn in January 2015.
  • Net issuance will, at the same time, remain significant in 2019, at around $1.2tn. US debt supply has jumped this year to fund the US administration’s expansionary policy. US net Treasury issuance has nearly doubled in 2018, to more than $1tn, with a dramatic increase in T-bills ($0.4tn).

Through 2018, US Treasury auctions have seen steady demand, supported by US households. The short part of the US curve offers an attractive yield for dollar investors. On the other hand, growth in foreign ownership has stagnated and the main foreign holders of Treasuries, China and Japan, have shrunk their portfolios of US government bonds this year. European and Japanese investors face some of highest hedging costs since the previous economic crisis.

All in all, we think that this huge rise in US funding needs in a context of lower liquidity will likely continue to be satisfied by dollar investors and will contribute to a tightening in global financing conditions. Thus, we argue that the potential rise in the long-term core government bond yield will be very limited.

 

 

Although we see the Fed defending its independence, there is the risk that political interference could prove counterproductive.

How do you assess the risk of rising political interference, and how could this influence Fed decision-making going forward?

We think that the Fed is defending its independence at a time of an uneasy relationship with a president who has openly criticised the CB. It is the case, however, that Donald Trump does not really have the means – without a majority in Congress – to threaten Fed independence. His remarks are therefore an attempt to intimidate the FOMC. That said, looking ahead, if Donald Trump were to further increase the pressure just as inflationary pressures intensify, it could encourage the Fed to raise its key rates more than it might otherwise in the absence of any political pressure. This is a risk that we cannot completely rule out. An increase in political interference could prove counterproductive regarding US economic performance.

 

 

Investment Talks US investor perspective on the FED Dec 2018-Header-1
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In what was one of the more highly anticipated Federal Reserve decisions of the past few years, the Federal Open Market Committee (FOMC) in December voted unanimously to raise rates by 0.25% to a target Fed Funds rate of 2.25% to 2.50%. The Fed’s focus was on continued strong US economic data from Main Street, rather than on swooning equity and credit markets on Wall Street. The Fed continued to focus on strong US GDP growth, underpinned by strong employment and inflation near their 2% target, rather than being driven by concerns about near-term weakness in global growth and tightening financial conditions. The market was expecting a dovish hike, but was caught off guard by the tone of the statement and the press conference, which was perceived as not being dovish enough.

From an investment perspective, despite the Fed’s less accommodative posture,we are beginning to see value in credit markets. Investors are now being better compensated for risk. We believe the rally in Treasuries has gotten ahead of itself and Treasuries are starting to price in a recession. But we see little risk of a recession in the coming year. On the USD, we believe that the upward pressure on the US Dollar should begin to wane as we have probably seen the maximum interest rate differentials between the US and other developed markets.

 

Key Takeaways from the December Fed’s Rate Hike

  • Fed Chairman Jerome Powell confirmed the 25 basis point hike and indicated that future rate hikes may peak at a lower “neutral” Fed Funds rate of 2.75% -- a level where policy is neither accommodative nor restrictive.
  • The Fed downshifted from autopilot to data dependent for future rate increases. This was reflected in the FOMC Statement where the language reflecting the rate path was altered from “expects” to “judges”.
  • The median projection of the Fed Funds rate for future years and long-term each were lower by 25 basis points, as a result of lowering forecast rate increases in 2019 from three to two. Given that longer run growth and inflation projections were little changed, the decline in the long-term expected funds rate likely reflects lower estimates of the neutral funds rate.
  • In the press conference, Powell indicated less flexibility with respect to the balance sheet runoff than markets had understood, saying the program was “on autopilot.”

While the FOMC moved forward in raising rates in December, they acknowledged that they will monitor “global economic and financial developments” in determining future rate increases. In other words, they appeared to recognise that the weaker global growth and sell-off in equity and credit markets spawning from their own rate increases and balance sheet reductions has engineered the financial conditions tightening now occurring. Their Statement of Economic Projections (SEP) indicated a change in the “dot plot”, so that the FOMC now projects only two rate increases in 2019 down from three from the September SEP. This change is consistent with the Fed’s view that the neutral rate may be lower than had been previously thought, as the longer run Fed Funds rate moved from 3% to 2.75%.

We were not surprised by the Fed’s December rate increase or their decision to reduce future rate increases. Current US economic data remains solid, led by a confident consumer. Wages have continued to rise, spurred by the 3.7% unemployment rate, which is well below the longer run estimates of 4% to 4.6%. However, we do believe growth has peaked. In fact, we anticipate that US GDP growth will slow towards neutral. Future growth expectations have been tempered by concerns about global growth. China’s GDP growth is decelerating amid an unresolved tariff situation, leading corporations to pull back on capital investment plans (which the Fed recognised in its statement). Rate increases, rising home prices, and the Trump tax legislation have resulted in slowing residential fixed investment. Finally, the stimulus from the tax bill and the 2018 budget is waning in 2019; the largest remaining impact will be from federal spending, and even that is expected to subtract from growth by year end.

We do not believe the change in the Fed’s posture toward future rate increases was a capitulation to pressure from the Trump administration. During the press conference, Chairman Powell was quite clear that political considerations played no role in Fed policy and defended the independence of the institution. The uneasy relationship between the Fed and the President is nothing new. In prior rising rate cycles, the central bank has often been at odds with the executive branch. No president wants to take responsibility for a recession brought about by the Federal Reserve.  

 

Investment Implications

Despite the Fed’s less accommodative posture, we are beginning to see value in credit markets. We anticipate that the economy is solid, even after somewhat slower growth and an expectation that the Fed won’t overdo it. Investors are now being better compensated for risk. We believe the rally in Treasuries has gotten ahead of itself and Treasuries are starting to price in a recession. But we see little risk of a recession in the coming year.

We had a period of a strong US dollar versus foreign markets as the Fed continued to systematically raise rates and shrink its balance sheet over the past two years. While the Fed tightened, other developed regions continued to maintain easy monetary policies. The faster growth in the US relative to the rest of the world continued to put upward pressure on the US Dollar. However, while this may continue for a little longer, it’s now clear the Fed is nearing the end of its rate hike cycle, and we have probably seen the maximum interest rate differentials between the US and other developed markets. The upward pressure on the US Dollar should begin to wane.

BOROWSKI Didier , Head of Macroeconomic Research
USARDI Annalisa , CFA, Senior Economist
AINOUZ Valentine , CFA, Credit Strategy
J. TAUBES Kenneth , CIO of US Investment Management
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Fed policy and US economy, what’s next?
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