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Investment outlook

Fed on hold to start 2020

Brian Nick
Chief Investment Strategist
A closeup of a crinkled dollar bill.
To no one’s surprise, the Fed chose to remain on hold at its first meeting of 2020. Last year’s three interest rate cuts appear to have helped ease financial conditions, and the Fed can now be patient in determining when – and what – its next move should be.  

Watch Brian Nick, Chief Investment Strategist, discuss the Fed’s latest rate action

What happened?

As expected, the Federal Reserve’s Open Market Committee (FOMC) held its policy rate steady in the 1.50% - 1.75% range. This was the second consecutive meeting at which the Fed declined to reduce interest rates after three successive cuts between July and October of last year.

There were very few changes to the Fed’s statement compared to the December version. The committee downgraded its description of consumer spending growth from “strong” to “moderate” and no longer describes inflation as “near” its 2% target. These small changes were interpreted as incrementally dovish for Fed policy.

In comments to the press after the meeting, Chair Jerome Powell mentioned the China coronavirus as a new source of economic uncertainty. However, Powell reiterated his stance from the last meeting that he expects the current policy stance to remain appropriate for the foreseeable future.

What comes next?

When the Fed last gave official word on the matter, a large majority of FOMC members did not expect to move interest rates up or down in 2020. That appears to still be the case based on today’s comments, as well as recent public statements from both the resident hawks and doves on the committee.

In looking for signals that it needs to move, the Fed has its sights set most directly on the labor market. Throughout the current expansion, private sector hiring has remained strong and wage growth has slowly but surely accelerated. While both hiring and wage growth softened somewhat in 2019, the unemployment rate remains close to an all-time low at 3.5%. The Fed still believes that this low jobless rate will eventually lead to a general rise in prices, but has also made it clear that inflation moderately breaching its 2% target for a short time will not necessarily compel it to hike rates.

Rate cuts also seem unlikely for the time being, given the improvement in U.S. housing data and the resilience in consumer spending. Further easing would likely only come in response to an unexpected and material deterioration in the outlook for growth.

The ongoing balance sheet expansion

Powell also addressed the Fed’s ongoing balance sheet expansion, stressing that it is not equivalent to quantitative easing. The Fed has been purchasing about $60 billion of Treasury bills each month to meet the high and growing demand for liquidity in the banking system. A perceived lack of such liquidity led interest rates in some cash markets to spike back in September.

In its statement, the Fed pledged to continue making those purchases at least through April. Direct Treasury purchases through open market operations were a normal part of the Fed’s operating model prior to 2008. As the Fed’s liabilities – chiefly currency in circulation – grow over time, so, too must its assets – chiefly U.S. Treasury securities – lest liquidity be drained from the banking system.

Even so, the ongoing asset purchases may be contributing to the recent calmness in financial markets, meaning their possible tapering (to use a loaded term) has the potential to reintroduce some volatility. Any such turmoil would likely be short-lived, however.

A year of stability for interest rates?

Evidence continues to mount that the U.S. economy is experiencing neither a robust acceleration nor an abrupt slowdown. If economic activity continues to expand at close to its current 2% pace, the Fed should be happy to remain on hold for the duration of 2020 after the last two tumultuous years.

Futures markets continue to price in a better chance of a cut than a hike this year. But the gap between the Fed’s current rate policy and the market’s expectations is narrower today than it’s been at virtually any time over the past two years. This should help anchor both short- and long-term interest rates. Indeed, we expect the 10-year U.S. Treasury yield to remain range bound between 1.50% and 2.00% for the foreseeable future.

Fixed income investors across the board would welcome a more stable year for rates, particularly those targeting higher-yielding parts of the market. We continue to see opportunities in investment grade U.S. corporate bonds, emerging market debt and high yield municipals, favoring a diversified approach to targeting higher income.
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Endnotes
Sources

Federal Reserve Statement, January 2020.
Bloomberg.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

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Glossary
A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
 
The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

A word on risk
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