Morgan Stanley
  • Wealth Management
  • Mar 25, 2019

Rising Risks for Investors from a Dovish Fed

The Federal Reserve surprised many investors last week with even easier monetary policy, suggesting it knows something we don’t.

Last week the already dovish Federal Reserve surprised me, as well as many other investors, by continuing to get even more dovish. It had already reversed its hawkish policy stance earlier this year, pausing its rate hike plans—one reason markets have mostly rallied so far in 2019 after a brutal selloff last December.

Then, last Wednesday, at the conclusion of their two-day policy meeting, Fed officials took the dovishness further by easing monetary policy in two ways.

First, they indicated that they won’t raise rates again this year—and maybe just one time next year—when many investors expected another rate hike this year and more next year. Second, they indicated they would conclude their balance sheet reduction program, known as quantitative tightening (QT), by September, earlier than expected. This move effectively adds more liquidity to U.S. markets, which, along with lower interest rates and easier financial conditions, would typically support stock market prices.

That’s not what’s happened so far, however. The bond market rallied at the news with interest rates falling (bond yields move inversely to bond prices). U.S. stocks, however, gained initially and then stumbled lower through the end of the week.

Market Reaction

There are several scenarios for why the Fed may have gotten more dovish, none of which is encouraging for markets. One is that the Fed sees worsening economic conditions ahead. A recession isn’t currently priced into equity markets, but investors may now have more reason to worry.

Another scenario is that the Fed is worried about the economy’s ability to sustain inflation at levels near its 2% target. However, with wages accelerating, oil prices at seven-month highs and the U.S. dollar weakening, Fed officials may find themselves behind the curve on inflation, having gotten too dovish and backed themselves into a corner.

Also worth mentioning is the possibility that the Fed is starting to bend to pressure from Washington. Investors have to be able to trust that the Federal Reserve is independent for it to achieve its broad goal of maintaining economic stability.

What seems clear is that the Fed is trying to stimulate inflation more aggressively than it has in the past. If inflation rises too much, the Fed may need to raise rates later this year. Morgan Stanley & Co. U.S. Economist Ellen Zentner forecasts another rate hike in December.  The potential for a surprise rate hike coming just a few months after extreme dovishness would be a recipe for volatility.

I think the Fed may be overplaying its hand. My suggestion to investors now is to consider options like adding gold, other real assets or inflation-linked bonds to their portfolios. These kinds of investments could act as a buffer to stock and bond markets if inflation rises, as now appears to be the Fed’s goal.

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