Market Outlook
2019 – To Neutral and Beyond?
 
 

Market Outlook

2019 – To Neutral and Beyond?

 

The short-term funding market landscape continues to evolve. While 2018 was a year characterized by the Federal Reserve methodically hiking rates, we expect 2019 will be different. As rates continue to rise, the end of the rate tightening cycle could be in sight.

There are a number of factors impacting the front-end markets, but we believe monetary policy decisions will have the most direct impact. This will be carried out broadly by interest rate policy and Federal Reserve balance sheet normalization.

 

KEY THEMES IN 2019

• The market will seek to understand the true definition of the neutral policy rate and the path towards that rate.

• Monetary policy is likely to continue to tighten through gradual rate hikes and balance sheet normalization.

• Liquidity yields are much more attractive and opportunities may arise if market and Fed expectations are not aligned.


 

Interest Rate Policy

The market debate entering the new year will likely be centered on “the neutral rate,” or stance of monetary policy that is neither accommodative nor restrictive. While much theoretical work has been done to estimate the neutral rate, challenges remain because the estimates are imprecise and complicated by other factors including both short-term (fiscal stimulus) and long-term factors (productivity growth and regulatory policy).

In the fourth quarter of 2018, we heard Fed Chairman Jerome Powell describe interest rates as both “far below neutral” and “just below the broad range of estimates for neutral,” which while seemingly contradictory, highlights the challenges of trying to predict the neutral rate. Rather than thinking of the neutral rate as a specific rate level, Chairman Powell prefers to think of neutral as a range of rates, which is currently believed to be between 2.5%-3.5%. Given this view, it is likely that we will enter 2019 very close to the lower end of the range.

A range this large presents some challenges to the market. On one hand, we are nearly within the neutral policy setting. But on the other hand, we would still be neatly within that range following four additional rate hikes. Market perception is that once the fed funds rate approaches neutral, the decision framework for further rate hikes could change. The decision to hike rates beyond the neutral setting will be more of a data dependent framework due in part to risks discussed later in this piece. Due to this belief, the market is discounting the Fed’s current expectations of three rate hikes in 2019. Will strong growth, employment and inflation data warrant moving policy into a restrictive mode? In addition, given the expected further rate hikes, the interest rate curve could continue flattening or inverting to a point where it could pressure financial conditions, which is a key metric that the Fed considers when analyzing data and economic indicators.

On top of all of this, the Fed’s commitment to greater transparency means that starting in 2019, there will be a press conference following every Federal Open Market Committee (FOMC) meeting. This doubles the amount of meetings that the market perceives as “live,” where an interest rate hike or major policy action could be announced. This change along with the aforementioned dynamics is creating uncertainty for the future path of interest rates and how portfolios need to be managed in response.

Display 1: Fed and Market Interest Rate Projections
 
neutral-and-beyond
 
 
 

Data as of November 25, 2018. Source: Morgan Stanley Research. Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.


 

Balance Sheet Normalization

Normalizing monetary policy is coming from more than just rising interest rates. Due to quantitative easing conducted during the global financial crisis, the Fed’s balance sheet ballooned to a peak of $4.5 trillion.1 Due to the FOMC’s balance sheet normalization program, the size of the balance sheet has decreased by $400 billion as of November 2018.1 Balance sheet run-off is now up to a maximum of $50 billion per month.

When normalization began in October 2017, former Fed Chair Janet Yellen hoped the program would be similar to “watching paint dry.” While it could be argued that the market impact has been minimal thus far, as the balance sheet unwind continues, potential supply and demand pressures will mount. If this happens, it could lead to wider spreads and higher yields in the short-term fixed income market.

Risks to the Outlook

In addition to the uncertainties surrounding Fed policy and balance sheet normalization, 2019 is shaping up to have a host of factors that could introduce risk into the global economy. These risks span the globe and arise from a myriad of sources. In the U.S., key questions center on the handling of the impending debt ceiling and slowing growth due to fading fiscal stimulus. Globally, cross currents in the market stem from uncertain trade policy and broader geopolitical concerns. Finally, we are beginning to see cracks forming in the credit market, with headline risk from the BBB, leveraged loan, and high yield markets. It is difficult to tell which of these factors might impact the markets or our outlook on monetary policy in 2019, but they are worth monitoring closely as we move into the new year.

Liquidity Markets Poised to Build on 2018 Momentum

With the renewed volatility in the global markets paired with rising rates, short-term investments are becoming a more meaningful part of asset allocation plans. Many cash yields are now in excess of inflation and the S&P 500 dividend yield. This means that your liquid investments can be accretive for the first time in years. Gradual rate hikes are likely to continue this trend in 2019.

Many investors take comfort in highly liquid short duration investments amid rising rates. This strategy was rewarded in 2018 as short-term benchmarks broadly outperformed their longer-duration counterparts. While the tide of Fed policy may be shifting, short-term fixed income investments will likely continue to be an important part of investors’ portfolios by providing liquidity and helping to minimize interest rate risk in these uncertain times. Across our portfolios, we will continue to focus on the key objectives of capital preservation and liquidity while opportunistically taking advantage of attractive risk-adjusted returns that present themselves in the market.

jonas.kolk
 
Chief Investment Officer of Global Liquidity
 
brian.buck
 
Executive Director
 
robert.leggett
 
Executive Director
 
 

1 Source: FOMC.

Risk Considerations

Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income.

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