Fed more dovish, but markets hoped for more

Market Flash

Fed hikes policy rate by 25 bps to 2.25%-2.50%
Fed delivers expected ‘dovish’ rate hike, but markets hoped for more softness
Committee still sees ‘further gradual increases’ as consistent
Median growth and inflation forecasts for 2019 are downgraded modestly
Markets are disappointed and return to risk-off. The US yield curve flattens further

The Fed hiked its policy rate yesterday as largely anticipated by 25 bps from 2%-2.25% to 2.25%-2.50%. Markets focusesd more on the new economic and monetary projections than on the interest rate decision itself. The median rate projections for the 2019-2021 period were revised lower by one full rate hike across the policy horizon compared to the September dots. The median dots are hinting at two additional rate hikes next year (2.75%-3.00%), a ‘final’ rate hike for this cycle is seen in 2020 (3.00%-3.25%). The policy target range is expected unchanged over 2021 (3.00%-3.25%). Interestingly, Fed members also eased their view on the long run neutral policy rate from 3.0% to 2.75% (was upwardly revised in September from 2.875 to 3.0%). As was already the case for the September dots, the dispersion of the Fed governors’ forecasts for the policy rates and for the neutral policy rate remains large. The balance sheet run-off ($50bn/month from Q4 2018 onwards) continues on its pre-set course. At the press conference, Powell said that that the impact of this balance sheet run-off has been small so far and that he didn’t see it creating problems. The Fed has currently no intention to change this process.

Regarding the economic variables, the Fed reduced the growth outlook for 2018 from 3.1% to 3.0% and for next year to 2.3% (from 2.5%). The growth outlook for 2020 (2.0%) and 2021 (1.8%) was left unchanged. The unemployment rate (cycle low at 3.5% next year) stays well below NAIRU (4.4% from 4.5%). Inflation is seen marginally softer but continues to oscillate very close the 2% target.

Source: Bloomberg

A ‘not-that-that dovish’ rate hike

The FOMC made some changes to the policy statement with regards to the September script, but the changes are rather limited given recent market developments and the intensive market debat on what future Fed policy will have to look like.

The economic assessment was almost unchanged, except for the Fed taking notice that the unemployment rate declined even further since September. Based on a similar economic view compared to September, the Fed concluded that ‘some’ further gradual increase in the target range for the Federal funds rate will be consistent with the Fed’s aim of sustained expansion of economic activity, strong labour market and inflation near the Committee’s symmetric 2 percent objective over the medium term. The FOMC still jugdges that risks to the economic outlook are roughly balanced. However, the Fed added it will continue to monitor global economic and financial developments and assess their impact on the economic outlook. One can see this as the Fed giving a sign to markets that it is well aware of recent economic and monetary developments.

In the press conference, the Fed Chairmain indicated that the FOMC still expects solid growth on 2019 after exceptionally strong growth in 2018, the best year since the financial crisis. The median growth projection for 2019 was downwardly revised from 2.5% to 2.3%, but is still wel above the long run neutral growth rate (seen at 1.9%). Powell admitted that there is some mood of angst about growth, but recent develoments haven’t fundamentally altered the Fed’s outlook. The US economy doesn’t need policy to be accommodative at this time. Howewer, the reduction in the 2019 growth forecast, among others, mirrors recent tightening of financial conditions. In this respect, the lower ‘dot plot’ should counterbalance and support the economy. The Fed Chairman said that neither the pace nor the destination of monetary policy is pre-determined. However, the reference to a strong economic context, suggests that the Fed still sees some upward tendency in the Federal funds rate as the more likely scenario. In this respect, yesterday’s Fed approach is less data- (and market)-dependant than many market participants had hoped for.

Markets and Fed continue to stay apart

Indeed, in the run-up to yesterday’s Fed decision, there was a big discrepancy between the Fed September dots and market expectations/hope on a much softer policy normalization going forward. In this context, the risk was a violent market reaction if the Fed didn’t come close enough to what the market hoped for. This is exactly what happened. The US yield curve flattened aggressively further.The 2-yr yield rose a meagre 1.9 bps. The 30-y yield dropped 8.7 bps. The 10-year yield (2.75%) is now testing the 2.81%/2.76%/2.7150 support area. A sustained break would suggest a fundamental shift in markets’ assessment of the economic and monetary environment. It would suggest that the market grows ever more convinced that Fed tightening might kill the economic cycle soon and much sooner than the Fed anticipates. The 10y/2y yield spread dropped to a cycle low of 11 bps. Despite yesterday’s Fed guidance, the market only sees a 40% change of an additional Fed rate hike by September next year!

US equity markets started the day with an optimistic bias and showed gains of about 1.5% going into the Fed decision. However, the Fed holding on to a scenario of ‘some’ further rate hikes, almost immediately turned investors sentiment risk-off again.

US equity markets closed the session with losses between 1.49% (Dow) and 2.17% (Nasdaq). The Fed’s intention to continue policy normalization and the risk-off sentiment also supported a limited comeback of the US dollar. The second reason probably was more USD supportive than the first one. The trade-weighted dollar rebounded back above the 97 handle. The dollar also reversed earlier intraday gains against the euro and the yen but both cross rates remain well within the established ranges. The EUR/USD 1.1187/1.1621 range remains solidly in place.

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