Throwing in the Powell: implications of the Fed policy shift

Jerome Powell has just executed the monetary policy equivalent of a screeching handbrake turn.

After suggesting late last year that interest rate hikes and balance sheet reduction were on a pre-set path – helping to prompt a torrid December for risk assets – the Chair of the US Federal Reserve this week reversed course.

Powell soothed markets both in terms of the central bank’s rates path and its balance sheet. The Fed said in a statement that its rate-setters will now be “patient”; and in a press conference, Powell indicated that they no longer have a tightening bias.

This was not expected.

Justifying the change, the Fed Chair pointed out that while the economic baseline remained similar, the risks had shifted. These included subdued inflation; economic uncertainty (slower external growth, Brexit, trade wars and the US government shutdown); and financial market developments.

Crucially, on the Fed’s unwind of trillions of dollars of asset purchases, Powell rowed back from earlier comments that this process was on “autopilot”. In doing so, he acknowledged that ‘quantitative tightening', as it is known, could stop suddenly if the economy were to deteriorate significantly.

In light of this about-turn from the world’s most important central bank, we have changed our macroeconomic views in a number of ways. We now believe that:

• The chances of the Fed making a policy mistake by becoming too restrictive have significantly declined
• In addition to other supportive factors, the Fed’s dovish shift lowers the probability of the US falling into recession later this year or early in 2020 – the cycle goes on
• Economic data will justify further US rate increases later this year, even though the Fed appears in no rush to resume tightening. We now see one hike in our modal forecast for 2019 (versus two prior to Fed’s January policy meeting)
• Evidence of continued above-trend growth, rising inflation and buoyant markets will likely be necessary for this hike to materialise

Ben Bennett, LGIM’s Head of Investment Strategy and Research, notes that it now sounds to investors like a rate cut might be just as possible in the coming months as a hike. The Fed’s new posture is negative for the US dollar and, as a result, positive for emerging market assets.

US payrolls figures are now particularly important, Ben adds, because the Fed needs growth to slow and inflation to remain absent to validate its new policy stance. This is also why, in his view, domestic US assets are not the obvious outperformers – if they rally too hard, the central bank may just remove the punch bowl again.

And Emiel van den Heiligenberg, our Head of Asset Allocation, stresses that the policy meeting was bullish for risk assets in general, as it reinvigorates the so-called “Powell put”, whereby the Fed comes to the rescue of markets whenever they suffer a bout of anxiety.

He thinks markets will only rally in earnest, though, once investors start to believe that a US recession is not likely to take place before 2021 or even later.

Emiel notes that within our multi-asset portfolios, we continue to favour a long position in emerging market debt and a tactically long equity stance – for now; the team also still prefers to be short of duration as global bond yields look below fair value.