December 18, 2019
Liquidity Outlook: Fed 2020: Raising the Monetary Policy Bar
December 18, 2019
2019 was viewed as a “mid-cycle adjustment,” where the United States Federal Reserve (Fed) cut rates three times as slowing global growth, muted inflation pressures, and policy uncertainty led the pivot away from projected interest rate hikes. Going into 2020, our expectation is that the Fed will likely adopt a “wait and see” strategy relying on the incoming data to provide a definitive signal that easier or tighter monetary policy is warranted. In our view, the bar to move rates in either direction is quite high.
2019: The Fed to the Rescue
At the tail end of 2018, market consensus expected the Fed to raise interest rates two times in 2019. But slowing global growth, volatile financial conditions and policy uncertainties from trade and fiscal policies spurred Fed Chair Jerome Powell to pivot to a more accommodative policy in early 2019. (Display 1)
1 As per December and June FOMC Summary of Economic Projections
2 Federal Reserve Board, actual
3 FOMC Meeting Statement, December 19, 2018
4 FOMC Meeting Statement, June 19, 2019
5 Jerome Powell, FOMC Meeting Press Conference, December 11, 2019
Despite the fact that job gains had been solid, unemployment rates were low, and the overall outlook for the U.S. economy was reasonably positive, the Fed also took into consideration the effects of global economic uncertainty. A weaker global backdrop, market volatility, China trade policy and Brexit uncertainty were all factors that prompted the Fed to reverse course, from expectations of two rate hikes, and deliver three 25 basis point rate cuts over the course of the year. This mid-cycle adjustment was a distinct deviation from the monetary policy of the past couple of years and set the target range for the Fed Funds rate at 1.50%-1.75%. In essence, the Fed stopped simply only looking at its dual mandate of maximum employment and price stability and started to focus on more macro global growth concerns. The monetary goal posts had been moved.
In another market-friendly act, the Fed injected cash into the market to help control short-term rates. Overnight repurchase agreement rates spiked in September, as demand for cash exceeded what the market was willing and able to lend. Low bank reserves, banking regulations, corporate tax payments, and U.S. Treasury settlements combined to cause a temporary shortage of cash in the system. The Fed helped to normalize the repo market through its temporary open-market operations. The combination of overnight and term open-market operations provided the market with more than $150 billion of needed liquidity. These combined operations have been extended through at least January 2020. In addition, the Fed also announced that it will purchase roughly $60 billion of Treasury bills per month into the second quarter. These two policies are designed to add reserves to the system and help control short-term rates. The Fed indicated the operations “are purely technical measures aimed at maintaining an appropriate level of reserves in the banking system and have no material implications for the stance of monetary policy.”
Interest Rate Outlook in 2020
This unusual reversal resulted in a bit of a roller coaster ride for monetary policy over the subsequent 12 months. Rates were on the rise at the onset of 2019, but declined throughout the balance of the year. The Fed’s balance sheet runoff probably went too far, and now has reversed course. For 2020, the market still faces uncertainties on many levels. The threshold to move the monetary policy bar is high and our baseline assumption is for the Fed to keep rates on hold in 2020.
The prevailing thought is that central banks have left policy appropriately stimulative globally and policy is in a good place going forward. Fed Chair Jerome Powell emphasized that “the current stance of monetary policy is likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook of moderate economic growth, a strong labor market, and inflation near our symmetric 2% objective.” The Fed is expected to be data dependent, assessing the outlook and risk to the outlook on an ongoing basis ─ a “wait and see” mentality. Generally speaking, the Fed would probably rather save some of their monetary policy ammunition for a material economic deterioration, as negative interest rates have not proven to be overly effective in either Europe or Japan.
There are some risks to this Fed policy. The hurdle for the Fed to move rates in either direction has been set relatively high, where economic data will need to definitively signal whether easier or tighter monetary policy is warranted. For example, a more stimulative policy could be needed if the weight of trade tensions or geopolitics slows global growth. A Fed response could come through lower rates, additional bond buying programs, or more definitive forward guidance. Alternatively, a tighter policy could be implemented in the event of an inflation overshoot or a swift resolution of global trade issues. In either case, it will take a “material” change in the Fed’s outlook to result in any near-term policy shifts.
Market Opportunities in 2020
As global yields remain near record lows, the stock of negative yielding bonds remains high, and as other asset classes have delivered strong 2019 returns, cash is likely to remain attractive. While a flat government yield curve provides investors little compensation for taking duration risk, short-term credit appears to be a compelling strategy given the low volatility of these assets and the attractive spread offered versus government securities.
The current yield spread between prime/short credit strategies over government securities is largely based on supply and demand dynamics. The market movement started with heavy U.S. Treasury issuance following the extension of the debt ceiling in mid-2019, which flooded the market with supply across the curve. As mentioned earlier, recent announcement that the Fed will purchase $60 billion of U.S. Treasury bills per month to help control short-term rates means additional competition for government securities, which will likely drive their yields lower.
Source: Bloomberg as of 12/20/2020
When looking at short-term investment opportunities, viewing the opportunity cost between 3-month LIBOR and 3-month Treasuries usually paints a clear picture on the relative attractiveness. The aforementioned market supply and demand dynamics have led to credit strategies having a much wider-than-normal yield spreads over government securities. Additionally, short-term credit spreads, shown by the difference in 3-month LIBOR and overnight rates, have also been elevated since these dynamics started surfacing earlier this year. In our view, these dynamics will likely continue into early 2020. Investors who are able to take advantage of the technical dislocations in the short-term markets may be able to opportunistically benefit by shifting an allocation to short-term credit.