Powell’s Fed and the Markets

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The Federal Reserve hiked rates as widely expected, but investors were not persuaded that it was hawkish.  Interest rates and the dollar fell as consequence.  What does this mean going forward? 

The Federal Reserve delivered the widely anticipated hike at Jerome Powell’s first meeting as Chair.  The Fed signaled greater confidence in the economy and increased the rate path by adding a hike in 2019 and 2020.  While the average forecast (dot) for this year rose, the median continued to anticipate two more rate increases this year.

Powell, more than Yellen, tried to play down the market’s focus on the dot plots (Summary of Economic Forecasts–SEP).  He argued that Fed took only one decision and that was to hike rates and cautioned against seeing the median forecast as the Fed’s view.   As Yellen had previously noted, albeit less forcefully, there are individual projections that are submitted and compiled, and are subject to change.

It is clear that officials have greater confidence that the dual mandate will be reached.  The statement and the forecasts reflected that the “economic outlook has strengthened in recent months,” and that inflation is expected to rise “in the coming months” rather than “this year” as the Fed previously said.   The statement recognized that household spending and business investment “moderated” after a strong Q4.

However, the fiscal stimulus, which Powell acknowledged, had a meaningful impact on the individual forecasts, is not expected to improve trend growth, even though the tax incentives encourage investment and may help boost productivity.  The median GDP forecast was lifted to 2.7% this year from 2.5% in December, and the 2019 forecast was raised to 2.4% from 2.1%.  Growth in 2020 and the long-term projection were unchanged at 2..0% and 1.8% respectively.

Unemployment forecasts were shaved, and the signal is that full employment is at hand.  This year, Fed officials expected the unemployment rate to slip to 3.8% from the December projection of 3.9%.  Further progress is expected in 2019, with the unemployment rate rallying to 3.6%, where it is expected to remain in 2020.  The long-term rate edged lower to 4.5% from 4.6%.

While the growth and unemployment forecasts seem hawkish, the Fed’s inflation forecasts are less so.  Consider that the median core inflation (PCE) forecast was unchanged at 1.9% and was lifted to 2.1% in 2019 and 2021 (from 2.0%).   Powell underscored the this by noting that there was no sense that the US economy is on the cusp of a surge in price pressures.

The Fed’s projections would leave the policy “modestly restrictive” in 2020, Powell said.   The median forecast for the Fed funds target this year was unchanged at 2.1%.  Of the 15 members of the FOMC, seven see at least four hikes this year and eight forecast three or fewer.  There are two dovish members that do not think that more hikes are warranted.  Bullard previously identified a this as his view, while the other dove is thought to be Bostic or Evans.  Next year’s median forecast was lifted to 2.9% from 2.7% and to 3.4% in 2020 from 3.1%.  The long-run equilibrium rate edged to 2.9% from 2.8%.

Given the economic optimism expressed in the statement and forecasts, the Fed kept its risk assessment balanced as it has been.  This is also understood to be less than hawkish.  This underscores the general impression that although official confidence that growth will strengthen with the help of the largest dollop of fiscal stimulus, underlying or structural economic forces and relationships, are not anticipated to change much.

It also speaks to the gradualism that will likely characterize the Powell Fed.  Raising rates at Powell’s first meeting as Chair creates favorable optics even if the Fed would have done the same thing had Yellen been given a second term,  However, Powell appeared to steer the Fed away from significant changes.  He acknowledged that the neutral interest rate as low and had not increased, but the Fed was open to the possibility.

There had been some speculation that Powell would indicate the intention to hold a press conference after every meeting (as we have been urging), and while it is something he is clearly considering, it was not announced..  We suspect if it were, that investors would see it as a tad hawkish, even though Powell said there would be no policy implication in the decision.

Although there was initially a volatile market reaction to the FOMC statement, investors settled on a benign interpretation of its decision and forward guidance.  The 10-year yield slipped a little more than a single basis point and returned toward the middle of its recent range (~2.80% to 2.95%).  The two-year yield, the most sensitive part of the coupon curve to Fed policy, eased by four basis points, the most in more than a month.  The two-ten year curve steepened slightly.

The dollar fell.   The euro had been flirting with this month’s low near $1.2240 but recovered smartly post-Fed to $1.2340.  The euro has been trading broadly sideways since making its high in the middle of last month.  As a reference, the 50-day moving average is found near $1.2330.  The trendline we have been monitoring drawn off that mid-February high and catching a couple of subsequent highs is now near $1.2380.

In a two-hour period beginning with the FOMC statement, the dollar set the session’s range against the yen, trading on both sides of the previous day’s range.  However, the outside day was neutralized by the close well within the recent ranges.  Indeed, for 10 of the past 13 sessions, the dollar settled at the end of the North American session between JPY116.00 and JPY116.50, and the other three times it closed below JPY116.60.

The Canadian dollar was recovering from its recent shellacking, and the outcome of the FOMC meeting was taken in stride.  The greenback’s 1.3% slide was the largest in more than three months and was the third consecutive losing session, the longest such streak since January.

The Australian dollar had initially made a marginal new low for the year before staging a strong comeback following the Fed’s decision.  The nearly 1.1% advance on the day was the largest this year.  The $0.7800-$0.7825 area is the main hurdle that needs to be overcome to signal another run toward $0.8000.

The US is expected to announce a series of measures targetted at what it judges to be intellectual property violations and practices as early as Thursday.  Powell was peppered with questions about trade and protectionism.  There seems to be little doubt that Powell prefers free-trade.  He noted that rising protectionism and the possibility of a trade war posed risks to the Fed’s outlook.

Separately, the Bank of England meets Thursday.  The market already was favoring a May hike, but Wednesday’s employment and wage data bolstered confidence.  Record high employment (rising by twice what was expected) and the lowest unemployment rate since 1975 is helping underpin wages.

Three-month year-over-year growth in average base earnings in January was 2.6%, the highest since late 2016.  Moreover,  the government has lifted the freeze on public sector pay (more than a million NHS employees will get a three-year 6.5% pay increase), and minimum wage is set to rise (almst 4.5%) next month.  While the US and Japanese economists and policymakers are struggling with the Phillips Curve, it seems very much alive in the UK.

Following the EC decision to proceed with the next stage of Brexit negotiations had already given a boost to sterling.  Even though several divisive issues, including the Irish border, are not resolved, there is a sense that Brexit is gaining momentum and the risks of exit without an agreement have diminished.   The broad dollar decline after the FOMC meeting saw sterling rise a cent from $1.4050.

The modest reduction of Brexit uncertainty for investors and businesses and the labor report leave sterling poised to challenge the year’s high seen in late January near $1.4345.   The euro has fallen back to the lower end of its six-month range against sterling (~GBP0.8700 area).  There is not much in the way of technical support, should it break, before GBP0.8600.  Prime Minister May’s stance against Russia, which is much different than when she was Home  Secretary, appears to be strengthening perceptions of her leadership. Local elections in May could still be the key to her tenure.