Fed policy outlook Looking through the storm for now
Investors have reined in expectations for US interest rate hikes. While the Fed is still overwhelmingly expected to raise rates in December, markets now see the central bank hiking just once more in 2019, a clear retreat from the three hikes in total expected in in early November.
There look to have been a few factors driving this reassessment.
- First, we have seen risk assets take a battering at home and abroad, with equity markets plunging and credit spreads widening.
- Second, Chair Powell and other FOMC members have struck a more cautious tone in recent communications.
- Finally, there have been one or two signs of weakness creeping into the US economy, particularly in interest rate sensitive sectors.
All of these dynamics bear monitoring closely. The Fed is already eight hikes into its tightening cycle and there is significant uncertainty over where equilibrium interest rates sit. However, recent bumps do not look large enough as yet to change our view that the Fed will deliver four more hikes, taking rates to a peak of 3.1% in late 2019. Should we see further sharp outbursts of stress, or signs that the growth is falling off more quickly than expected; this would likely trigger an earlier halt.
What will the Fed make of recent market disruption?
Following sharp declines last week the S&P 500 is down around 9% from its 2018 high – the fourth big dip in the index over a bumpy year. The narrative around this decline has been varied, although common explanations include concerns around rising margin pressures, higher discount rates, a worsening earnings growth outlook and trade risks. In some respects the decline might reflect some of the excesses coming out of the index, following a temporary boost to profit growth from tax cuts. Indeed, the recent adjustment might better capture the more challenging growth and inflation trade off in store for the US over coming years. While this reset is clearly painful for holders, the S&P is still only back to levels seen around the start of the year. We would probably need to see larger and more sustained declines before the Fed became alarmed about what this stress was signalling around the economic outlook, and the knock on effects this might have on the broader economy.
S&P 500 equity index
Source: Bloomberg (as of November 2018)
Credit spreads meanwhile have widened on similar fears, with the high yield OAS spread pushing above 400bps. This provides one of the inputs into our recession probability frameworks, with credit spreads typically a robust indicator that the risks of a downturn in the short term are increasing. However, from a historical compassion the recent move has been relatively orderly, thus far. Indeed, the Fed would probably be inclined to look for a much larger rise in the HY spread before it became really alarmed. This might not have to be as large as the 2015 and 2016 experience, given that was associated with blow-ups in the energy sector. However, a further blow out to say 500-600bps would provide a stronger signal that the market is really worried about credit quality as rates rise.
US HY credit spreads
Source: Barclays Line chart (as of November 2018)
Finally, it is worth thinking about the yield curve, particularly in relation to the equilibrium rate question. The 2s-10s spread has been on a bit of a round trip over recent months, but it is interesting that the latest market vol has not been associated with further pronounced flattening. This might reflect the perceived shift in Fed tone, and pricing out of short term rate hikes. If we are right and the Fed delivers more tightening than currently priced, it will be interesting to see how the market reacts. A large and rapid flattening in the curve would tell us that the market thinks that a policy mistake is taking place. This may cause some more consternation at the Fed.
UST 2s-10s spread (bps)
Source: Bloomberg (as of November 2018)
As short term interest rates rise we would expect to see financial conditions tighten. This has been the case over recent months, with the Goldman Sachs Financial conditions index identifying a clear shift higher, albeit to levels below historical averages. Our research finds that tightening financial conditions are more likely to be associated with outbursts of financial stress. Such an outburst has materialised over recent weeks, and our financial stress index has picked up this spike. However, this needs to be placed in context. While stress has increased sharply, it also remains below the long term average for this index. To compare, this spike looks similar to that experienced earlier this year. Overall, we would probably need to see another bout of disruption of a similar magnitude to that seen over 2015 and 2016 to prompt a shift in monetary policy. This would entail another notable tightening in financial conditions and outbreak of financial stress from here, in order to push both of these indicators above their long term averages. This would likely ring alarm bells more forcefully at the Fed (and other central banks), albeit their policy choices are more complicated at present given still strong growth and signs of building inflationary pressures.
US interest rates, ASIRI financial stress index and GS financial conditions index
Source: ASIRI, Bloomberg, Goldman Sachs ( as of November 2018)
How much damage are higher rates doing to growth?
Interestingly, there have been signs of weakness creeping into parts of the economy over recent months. This has perhaps been most obvious in the interest rate sensitive housing market, where new and existing home sales are down sharply, prices have softened and residential investment has been weak for a number of quarters (we will publish a note on this sector next week). Interest rates look partly to blame, with the 30yr mortgage rate up 70bps this year. However, this may not be the only driver, with affordability stretched and recent tax changes blunting the ability to use housing as a tax shield. With these drags in mind, we already have residential construction weighing on growth over our forecast horizon. The bigger surprise could come from broader business investment, which was surprisingly soft in Q3. We have forecast a rebound in this activity over the 6 months, but the core durable goods last week poses a clear risk to this.
Looking at these data, it is hard to identify at this stage how much of the slowdown is payback from a very strong run, and how much is a genuine softening as trade uncertainty builds and global activity wanes.
The Fed flagged this weakness in its November policy statement and will be watching these indicators closely
US composite house price index
Source: Bloomberg/ Haver (as of July 2018)
Despite spots of weakness, the aggregate economy is still growing strongly. Our nowcast is pegging growth at 3.3% in Q4 at this early stage in the data cycle, above our judgemental forecast of 2.5%. Looking ahead to 2019, we have consistently flagged a clear slowdown in activity, although growth only falls below trend later in the year. Indeed, while fiscal stimulus is set to fade, it should still be providing support over the next couple of quarters, as should a small boost to consumption from lower oil prices.
Above trend growth increases the urgency at the Fed to adjust policy. Indeed, this suggests that we will see further inroads into an already tight looking labour market. Certainly payroll employment growth has been running hot, with 216 thousand new jobs created a month on average over the past 6 months. This is well above the average increase in the labour force of 116 thousand persons a month seen over recent years. Initial claims have started to track a little higher, suggesting some moderation in employment growth from here. However, this looks to be at least partly down to seasonal effects and natural disaster related distortions. The continued tightening in the labour market does seem to be feeding through to some acceleration in wages. Over the past six months average hourly earnings have picked up to 3.3% in annualised terms, while the employment cost index is up 2.7% over that period. The Fed can take some comfort from more benign trends in unit labour costs, with better productivity helping ease some of these pressures. However, it is increasingly aware of the need to avoid overheating in an economy that is still growing strongly and moving beyond full employment.
Source: Haver/ Bloomberg (as of Q1 2018)
A shift in stance at the Fed?
The messages from the Fed have been more cautious over recent weeks. In part this shift has helped to pull back some very hawkish rhetoric from Powell, who warned back in September that the central bank was a “long way from neutral”. In particular there has been a greater acknowledgement from the Chair of deteriorating global growth prospects and the increased need to be highly data dependent in the current environment. Clarida’s speech today “Data dependence and US monetary policy” was unsurprisingly heavy on the data dependence theme too, arguing that these data should allow the Fed to update its views on where the economy is headed cyclically, but also where equilibrium interest rates and unemployment rates might sit. Williams meanwhile has flagged that the Fed will be raising rates “somewhat”, in the context of a very strong economy. Powell is due to speak tomorrow and it will be interesting to hear if his language has shifted any further.
The evolution of the Fed’s communication makes sense in many ways given some of the risks and uncertainties emerging in the current outlook. Moreover, part of this shift is natural as the central bank starts to get closer to its view of where equilibrium policy rates might sit. Certainly these comments should be seen as signs that the Fed will be highly data dependent over coming quarters, and have an open mind with regards to when the bite from policy rates hitting equilibrium might take hold. Using this framework, the messages from policymakers around the domestic economy have still been upbeat of late, with each member signalling the need for further tightening. Further forward, the decline in forward guidance and shift towards strong data dependence might spur some more volatility around rate expectations, as markets look to decipher changes in the economic environment, and how these might be interpreted by policymakers.
What we will get in December?
Barring another large and sustained outbreak in market stress over coming sessions, it is very likely that rates will rise, putting the onus on the Fed’s broader communications. On this front it would not be a surprise to see the recent shift in rhetoric continue. Powell is likely to be more cognisant of a difficult global backdrop, domestic market stress and pockets of weakness in the US data. Similarly, we would expect another clear steer that the committee is highly data dependent. However, at this stage, we will probably only see small changes in the FOMC’s growth and underlying inflation projections – although lower oil prices will pull down headline 2019 CPI estimates.
On interest rates, the Fed is currently signalling a hike in December, three hikes next year and one in 2020 in its median dot plot. We have to be a little careful to not focus too heavily on where the median lies, given that some individual voters such as Powell will obviously be far more influential. However, it will be interesting to see if some of the dots fall a little. With the distribution finely balanced in both 2019 and 2020, it would take only a couple of moves to bring the median rate projection down. This would suggest that fractures are developing within the committee about how to interpret recent developments. From a market perspective a shift down could be seen as the start of a retreat from accommodative policy, or a sign that the Fed is still intent on delivering more tightening than it has factored in.
Overall, we continue to expect three more hikes over the course of 2019, taking rates to a cyclical peak of 3.1%. That view would be challenged if market stress continues to build significantly, signalling weaker future activity and directly contributing to a slowdown by tightening financial conditions. In this event we would expect the Fed to pause and potentially delay tightening. Indeed, this could be seen as a signal that the neutral interest rate is lower than the 3% currently projected by the median member of the FOMC. Similarly, a sharper than anticipated deterioration in growth could tell the committee that policy is becoming tight and it should shelve plans to raise rates further.
Finally, the balance sheet provides something of a wildcard at this stage. We wrote about the issues the Fed was having with the Fed Funds rate in a previous email (attached), as declining reserves pushed this key rate towards the top of its target range. This may prompt another “technical adjustment” in the interest on excess reserves, with this rate hiked just 20bps in order to help keep the effective Fed Funds rate closer to the middle of its published corridor. This technical nudge aside, a more important question is why is this drift persisting? The Fed continues to argue this is a result of Treasury bill supply, pushing up repo rates, with “no signs that the upward pressure on the federal funds rate relative to the IOER rate was due to scarcity of aggregate reserves” in the September meeting minutes. It will be interesting to see if this message has changed in the minutes from the November FOMC meeting, released later this week. The Fed is expected to continue with its balance sheet roll off through 2019, before drawing this to a close in 2020. However, if it sees clearer signs of reserve shortages, it will need to draw a halt to this roll-off earlier – with clear implications for asset markets.
Fed policy target range and effective fed funds rate (%)
Source: Haver/ Bloomberg ( as of November 2018)
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