What is the Federal Reserve’s plan for 2020?
The final Federal Open Market Committee (FOMC) meeting of 2019 delivered few surprises. The U.S. Federal Reserve’s (Fed) policy rate was kept unchanged at 1.5% -1.75%. Its latest version of the Summary of Economic Projections remains largely steady and it expects the policy rate to stay unchanged for 2020. Given the current trajectory of economic growth, this strategy is a sensible one. However, the risk to the policy rate remains heavily skewed towards the downside. This would imply the chance for bond yields to surge remains limited. Loose monetary policy from other central banks will continue to put downward pressure on global interest rates. The hunt for income for Asian and global investors continues.
The Fed strongly indicated at its October meeting that its precautionary monetary easing has come to an end, after three cuts totaling 75bps in the summer. Thus far, the economy is still operating with decent momentum and retail sales during the holiday season seem to be robust. The November non-farm payrolls was particularly strong, rising by 266,000, well above the consensus expectations of 180,000. The unemployment rate declined to 3.5% as well. While the Institute for Supply Management manufacturing headline index remains below 50, manufacturing purchasing managers’ indices (PMI) around the world are starting to stabilize. The Fed was particularly concerned that the U.S. economy would be dragged down by the global economy. An improvement in global PMI data should help to sooth such worries.
Another issue concerning the Fed was the U.S.-China trade war. The ongoing negotiation between the two sides has yet to yield an agreement, but this shows signs that both Washington and Beijing are unwilling to escalate this tension further. Another truce may not be sufficient to revive business sentiment, but it should also help corporate investment to find a bottom. The rate cuts have pushed U.S. government bond yields lower, while keeping corporate credit spreads tight. This implies the U.S. corporate sector should not find it difficult, nor expensive, to borrow if needed.
Since we expected the U.S. economy to grow at 1.5-2% in 2020, these arguments are allowing the Fed to hold policy rates in the foreseeable future, and maintain some ammunition to deal with recession threats when they come. The Fed may also want to avoid major policy changes as the U.S. approaches the 2020 elections.
Looking further into the horizon, the risk to policy rate remains firmly on the downside. The U.S. economic expansion is already one of the longest in history. The chance of a large fiscal stimulus that could push growth back to above average is low given the division in the Congress. The Fed is also expected to review and see if it should change its inflation target to “averaging 2% over an economic cycle” rather than just 2%. If adopted, this would allow the Fed to keep rates lower for longer in order to allow inflation to run above 2% to compensate for undershooting its target in the past. Meanwhile, other major central banks are expected to keep the monetary policy loose given the lack of inflationary pressure around the world.
EXHIBIT 1: Federal funds rate expectation
FOMC and market expectations for the fed funds rate
For Asian investors, the Fed’s policy outlook has a number of implications. First, Asian central banks are likely to keep their cash rates low given the Fed’s policy. Hence, Asian investors will need to keep searching for income and yield via a diversified portfolio, including fixed income, high dividend equities and alternative assets. Cash is unlikely to generate the necessary return to beat inflation and preserve purchasing power.
Second, global investors are also expected to continue to strive for yield. In fixed income, a relatively low risk of recession should continue to support developed market corporate debt. This macroeconomic backdrop should also benefit mortgage-backed securities (MBS) and asset-backed securities (ABS) in the U.S. A stable U.S. dollar could also persuade investors to look for yield in emerging market fixed income. Overall, these fixed income asset classes all require active management to manage risks, but in a low yield environment, institutional investors would be prompted to explore these choices more closely.
Third, for U.S. Treasuries, the current yield may not look attractive, but investors should not forget the potential capital appreciation when bond yield falls in the years ahead, especially if economic growth slows significantly. This does fundamentally change how investors use U.S. government bonds to build their portfolios. Instead of just focusing on income, capital gain becomes an important consideration.