The Fed is the investor’s friend after all

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By:
Peter Lee
Published on:

With new voting FOMC members queuing up to proclaim their reluctance to raise rates further, it only remains to be seen how flexible the Fed will be on balance-sheet reduction.

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Fed chair Jerome Powell


A few tweets from the Tariff man, an equities correction as close to a bear market as makes no difference, and suddenly the Federal Reserve has changed its tune.

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Eric Rosengren,
Boston Fed

In a speech on Wednesday, Eric Rosengren, president of the Boston Fed, talked up the generally optimistic forecasts of economists in contrast to the sour tone of financial markets recently. 

But he also conceded: "If the pessimism evident in financial markets eventually shows through to economic outcomes, there would be less need, and perhaps no need, for further increases in interest rates." 

Who says jawboning the Federal Reserve doesn’t work? This is a decidedly different message from December when the Fed raised rates, even as it cut its projections for 2019 to two further likely 25bp increases in the Federal fund rates, from three previously indicated.

James Bullard, president of the St Louis Fed, went even further, telling the Wall Street Journal even as Rosengren spoke at the Boston Economic Club, that the US central bank is “bordering on going too far and possibly tipping the economy into recession” if it continues to raise rates.

Bullard and Rosengren, who were alternate members of the Federal Open Market Committee in 2018, will be full voting members by the time it meets again at the end of January.

Changing tune

Brian Jacobsen, senior investment strategist at Wells Fargo Asset Management, says: “Fed officials have been changing their tune from data dependency to flexibility. Data tend to be lagged, almost assuring that the Fed would be sluggish to respond to changing conditions. Flexibility seems to imply not only that the Fed will listen to the messages being sent by markets, but also that it won’t just put its balance sheet normalization plan on cruise control.”

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Matt King, Citi

Matt King, credit strategist at Citi, emphasizes the importance of the $1 trillion decline in central bank purchases of financial assets in 2018 and the sharp slowdown in credit creation, which had previously created marginal buying and driven up prices. 

King judges that in recent price declines in both equity and credit markets, “the short-term correlations with central bank purchases are both astonishing and disturbing”.

Bank reserves have been shrinking with the Fed’s balance sheet and that could eventually lead to tighter credit conditions. 

Minutes of the FOMC meeting in December were published on Wednesday and show that some participants commented on the possibility of slowing the pace of the decline in reserves, should upward pressures on money market rates emerge.

The minutes also record many participants expressing the view that, especially in an environment of muted inflation pressures, the committee could afford to be patient about further policy firming.

Andreas Johnson, US economist at SEB, notes that while the Fed hiked the Fed funds rate from 2.25% to 2.5% in December, “the minutes from the December meeting are more dovish than the meeting statement”.

Resumption of bull

Markets have rallied in response to all this talk of renewed accommodation. Could this herald resumption of the bull market?

Chair of the Fed Jerome Powell set out in his speech to the Economic Club of Washington on Thursday to portray the Fed as no slave of the markets or politicians who want credit for them going up.

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Brian Jacobsen,
Wells Fargo
Asset Management

Jacobsen says: “The big message from Powell was to just underscore what he said in Atlanta [at the start of January]. Monetary policy will not be dictated by the market, but the Fed is not deaf to the concerns expressed by the market."

Joseph LaVorgna, US economist at Natixis, agrees with King that recent years have shown an uncanny relationship between the variation in the supply of effective marketable treasury securities and stock market returns.

“Presently, the Fed is at a critical juncture: caught between tight financial conditions and a balance sheet runoff that is on autopilot,” he says.

LaVorgna points out that massive treasury issuance and waning Fed demand raises the possibility of a crowding out of risk assets as private investors will have to absorb more of this treasury supply.

However, he suggests that, “recent comments made by chair [Jerome] Powell and the minutes released yesterday suggest that the Fed may alter its balance-sheet policy at some point this year”. 

A flexible Fed should be the friend of investors, suggests Jacobsen.

“Rather than fearing that the Fed will hike until it hurts and not realize it hurts until it’s too late, a flexible Fed is one intent on sticking the landing and not inadvertently tipping the economy into a recession.”