ECONOMIC UPDATE


  • Riskier assets bounced back in January following a rough end to 2018
  • A more dovish Fed was the primary source of improved sentiment
  • At the January meeting, the FOMC called for “patience” regarding future policy decisions, and a separate statement pertaining to balance sheet normalization revealed some unexpected insights

Market sentiment was notably improved in January following the dismal performance for risk markets in December. The S&P 500 generated an 8.01% return in January on the heels of a 9.03% decline the prior month. There was a similar bounce in high yield corporate debt, with the ICE BofAML 1-5 Year US High Yield Index outperforming Treasuries by 341 basis points (bps) versus a negative 317 bps excess return in December. Some attributed the rebound to the “January effect,” a long-standing hypothesis that there is a seasonal anomaly/technical in financial markets where prices of riskier assets increase more in January than other months. However, a big boost for risk markets to begin 2019 was the perception of a more dovish Fed. A consistent theme from Fed leaders throughout the month was “patience” with regards to future policy actions, and FOMC meeting on January 30 reflected this theme, as discussed in more detail below.

While the Fed has been the major driver of market sentiment in recent weeks, there have been other events on the radar of investors. Most notably has been the progress, or lack thereof, in negotiations between the United States and China on trade and other related issues. Officials from both countries met in Washington last week, and the ensuing press conference suggested it was a very positive meeting. However, the pressing question for markets is if and when tariffs will be lifted by each country. Regardless, the odds of a détente between both parties have increased, which would be a well-received event by global markets. It now appears that a delegation of U.S. officials will travel to China in early February to continue talks, and reports suggest President Trump could meet with Chinese President Xi in late February following Trump’s summit with North Korea.

As the Doves Turn
The January 30 FOMC meeting was much anticipated by market participants. This anticipation was not related to any expectation of a rate hike or other policy action, but rather the tone of the official statement and Fed Chair Jerome Powell. Investors were generally expecting at least a slight pullback from the hawkishness of the December meeting, and they ended up getting more than they bargained for. The official statement included material changes, all of which struck a more dovish tone.

“In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate…

The bolded words in the excerpt were new additions to the statement, and it marks a clear shift from the programmatic rate hikes of the prior two years to a “patient” and data-dependent approach amid “muted inflation pressures”. This change was not necessarily a surprise given recent Fedspeak, but the discussion regarding balance sheet normalization was more unexpected.

The use of asset purchases as a monetary policy tool in the aftermath of the Great Recession was uncharted territory for the Fed. For much of the policy normalization process to this point, officials had effectively bifurcated rate hikes and balance sheet reduction in that the latter was simply a reversal of an extraordinary policy tool that was no longer necessary. In other words, even if the Fed was to pause rate hikes, it seemed clear that they would continue with balance sheet normalization. On January 30, Powell suggested that the Fed could end reinvestment tapering sooner than previously expected and leave more reserves in the banking system. Perhaps, more importantly, the separate press release issued by the Committee on balance sheet normalization suggested the Fed now intends to use asset purchases as a future policy tool. As the release noted, “the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” The statement did state clearly that changes to the federal funds rate will continue to be the primary method of adjusting monetary policy, but quantitative easing is no longer considered a “one-off” strategy amid extraordinary circumstances.

As noted in last month’s commentary, it appeared, at least for a moment, that the current Fed regime was resisting the temptation to capitulate to financial markets during periods of heightened turbulence. Powell stood firm at the podium following the December FOMC meeting, suggesting that the Fed would press forward with policy normalization despite pressures from the White House and falling stock prices. Fed policymakers appeared to be less concerned with financial stability risks just one month later, unless that was not really their primary concern in making the decision to be more hawkish at the December meeting. Nevertheless, the January meeting was notably more dovish, and the minutes of that meeting will be closely scrutinized by market participants, particularly the discussion surrounding balance sheet policy...

 

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