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December 18, 2019
Liquidity Outlook: Fed 2020: Raising the Monetary Policy Bar
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December 18, 2019

Liquidity Outlook: Fed 2020: Raising the Monetary Policy Bar


2020 Outlook

Liquidity Outlook: Fed 2020: Raising the Monetary Policy Bar

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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)

 
 
 
Display 1: The Unusual Evolution of Monetary Policy
 

1 As per December and June FOMC Summary of Economic Projections

2 Federal Reserve Board, actual

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. 

 
 
 
Display 2: The Opportunity Cost in Short Term Investing
 

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.

 
 
 
The Global Liquidity team aims to effectively meet clients’ unique cash and working capital needs, offering a broad range of money market funds and customized separate account solutions.
 
 
 

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

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The ICE 3 Month USD LIBOR Index tracks short-term interest rates for the London Interbank Offered Rate (LIBOR), which is the short-term interest rate that banks charge one another and that is generally representative of the most competitive and current cash rates available.

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DISTRIBUTION

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA, authorised and regulated by the Financial Conduct Authority. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Ireland: Morgan Stanley Investment Management (Ireland) Limited. Registered Office: The Observatory, 7-11 Sir John Rogerson's, Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662.  Regulated by the Central Bank of Ireland. Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the U.K., authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich BranchI Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0)44 588 1074.

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U.S.

A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley Funds.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A BANK DEPOSIT

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”), (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore.  Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

IMPORTANT INFORMATION

EMEA: This marketing communication has been issued by Morgan Stanley Investment Management Limited (“MSIM”). Authorised and regulated by the Financial Conduct Authority. Registered in England No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

A separately managed account may not be suitable for all investors.

Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing.

The views and opinions are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment teams at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This material is a general communication, which is not impartial and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. All investments involve risks, including the possible loss of principal. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Past performance is no guarantee of future results.

Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

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All information contained herein is proprietary and is protected under copyright law.

 

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