When Fed Chief Jerome Powell took to the lectern at January’s Federal Open Market Committee (FOMC) meeting, he said he would be “patient,” and that rates could well be hitting the lower bound of neutral. That was an abrupt turnaround from his December script, when he was intent on raising rates.
Investors jumped to the conclusion that the rate pause actually signaled the end of rate increases, and stocks rebounded. Certainly, Powell gave no hint as to when the next rate move would be, but for investors to rule out any increases in 2019 seems like a heroic leap. There are a number of reasons to expect the Fed to return to raising rates in June.
Was Powell Intimidated?
Powell would not be the first central banker to feel intimidated by the markets. In 2013, bouts of market volatility convinced Ben Bernanke to postpone efforts to trim asset purchases, as he responded to a market fit that was colorfully labelled “the taper tantrum.” In 2016, Janet Yellen scaled back her ambitions for four rate increases to just one, as markets recovering from oil price weaknesses balked.
Powell’s recent epiphany on the need for “patience” follows in that vein. His emphatic dovish tone, assurances that rates are knocking on the door of neutral, and his intent to still maintain a hefty Fed balance sheet were a gift for markets.
Right now, the Fed Fund Futures contract, which reveals the market’s view of rate trajectories, expects the Fed to cut rates within a year. That outlook is consistent with near-term recession fears, or at least a draconian downgrade to U.S. growth.
Fed Funds Futures Rate
Fed funds futures rate Sun Life
However, the pillars of U.S. growth still look solid. Unemployment remains near record lows.
Consumer confidence is still robust. Wage growth is boosting spending. Manufacturing is growing and inflation expectations remain well-anchored. While housing struggled for most of last year, it is starting to improve and mortgage applications recently jumped to a multi-year high.
2018 Gross Domestic Product (GDP) hit a cyclical high of 2.9%, ignited by the initial surge of tax breaks. 2019 is expected to deliver a respectable 2.5% and settle around the trend of 1.9% in subsequent years. Financial conditions that bottomed on December 24, just as the equity market hit a low, are starting to improve and should boost confidence in the next several months.
Bloomberg’s Financial Conditions Index
Bloomberg Financial Conditions index Sun Life
The chief exogenous risk continues to be trade tension with China. But negotiations are continuing and the tone is positive. Agreements on reducing the trade deficit through purchasing more U.S. agricultural and energy products should be wrapped up before the deadline.
While more complicated structural issues, such as market access, intellectual property abuse and unfair local company subsidizes don’t come with quick fixes – an extension will likely be needed. Nevertheless, any progress will lift global sentiment.
Global Growth Needs Help From China
While the U.S. is a fairly closed economy, with exports making up a mere 12% of GDP, it is not immune to tremors in other large economies. Right now, China poses a risk to global growth as its economy slows, with retail sales dipping to a 15-year low while manufacturing contracts to a multi-year low. Layoffs are also cropping up in export-related sectors.
China is hitting back with stimulus. Consumer tax cuts, monetary accommodation and public spending are all part of the package. The stimulus is expected to stabilize the outlook for the second half of the year. Progress on trade is a critical pillar to restoring global confidence.
The U.S. realizes they cannot highjack China’s growth and expect to have no collateral damage at home. And both leaders are motivated to post some wins: President Trump, as he gears up for his re-election cycle, and China’s President, Xi Jinping, as he hosts a celebration of the 100th anniversary of the Communist Party in 2021. Neither will want a slumping economy on their report card.
Powell’s Next Step
The Fed pause will help markets consolidate the four rate hikes from last year. While the U.S. economy is slowing, there are few cracks that suggest a recession is in the works. However, as Powell emphasized in his January update, there are a number of headwinds impacting growth across the globe. Therefore, the Fed’s dovish stance is good news as other central banks can hold off on tightening and help offset some of the stress.
The second half of the year should provide an improving backdrop as risks mitigate. Chinese stimulus will have had time to kick in, trade spats should be closer to resolution, Brexit risk should abate and European growth should improve as demand stabilizes.
The Fed is not done yet. Markets will eventually have to concede that there is more left in the growth tank. Expect the Fed to return to raising rates in June.
This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.