April 18, 2019
The Empathetic Fed
Expectations now call for zero rate hikes in 2019, with a greater chance of a rate cut than a hike per market projections.
Through 2018, the Federal Reserve (Fed) continued its tightening path via four rate increases, balance-sheet reduction, and two more rate hikes projected in 2019. By March 2019, expectations called for zero rate hikes this year (with a greater chance of a rate cut than a rate hike per market projections(1)), a reduction and then pause in the balance-sheet run-off, and future projections of only one hike in the next 18 months. What spurred this change in action and outlook? In this commentary, we explore how we arrived here and frame the drivers of future rate decisions.
An Unconventional Decade
Following the financial crisis of 2008, the Federal Open Market Committee (FOMC) essentially had two phases to its monetary policy. The first phase consisted of extreme liquidity and support for the economy and markets. Conventional policy reduced the overnight rate to near 0%. This zero-bound level remained in place from 2009 to 2015. In addition, the FOMC entered a realm of unconventional monetary policy by launching its quantitative easing program—buying trillions of dollars of government bonds and mortgage-backed securities. The result was a balance sheet ballooning from approximately $1 trillion in 2008 to $4 trillion by 2014. This accommodative backdrop helped provide markets liquidity and security, which contributed to risk sentiment, pushing the S&P 500® index from its lows of 770 points in March 2009 to more than 2,700 points entering March 2019. While risk assets performed well during this time, U.S. gross domestic product (GDP) growth (from 2008–2018 annual U.S. GDP) grew on average by 1.6%, with the U.S. 10-year Treasury rate averaging 2.62%.
Note: Since 1977, the Fed has operated under a mandate from Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”(2) The goals of maximizing employment and stable prices are referred to as the “dual mandate” of the Fed. Anecdotally, under Ben Bernanke’s Fed Chairmanship in 2012, the Fed, for the first time, expressed an implicit inflation target of 2% that it seeks to maintain.
Inversion GDP growth will be key in sustaining short-term rates...
...Though global long-term rates are suggesting slower growth
In the latter half of the past decade, we saw the Fed enact the second phase of its monetary policy plan by unwinding, or “normalizing,” some of its accommodation. In October 2014, the FOMC made the decision to continue purchasing assets, but not to the point of further inflating the balance sheet. Fifteen months later in December 2015, the Fed increased the federal funds target rate for the first time since June 2006. Exiting December 2015, monetary “normalization” has resulted in nine interest-rate hikes and monthly sales of approximately $60 billion of balance-sheet assets. This “less accommodative” stance seemed to be a standing fixture . . . until now.
What Has Changed?
What inputs changed that could have contributed to a revised outlook and altered the Fed’s policy action from the end of 2018 to the beginning of 2019?
Global Growth—Slowing global growth has become a constant headline as the U.S. and other international bodies deal with increasing economic drag. The U.S. grew at 2.5% GDP in 2017. The FOMC economic projection for 2019 growth is currently 2.1%.(3) Similarly, European Union (EU) GDP growth in 2017 was 2.5% versus recent European Central Bank growth projections for 2019 of 1.1%.(4) Further strengthening the case for a slowdown in global growth is the negative outlook held by economists surveyed via Bloomberg as they see China growth slowing to 6.2% in 2019, from 6.6% in 2018, and easing further in 2020 and 2021.(5)
Capital Markets—The S&P 500 index declined by 13.52% in the fourth quarter of 2018, coinciding with severe spread widening of risk premia across fixed-income asset classes (Table 1). The lack of year-end new-issue activity in the credit markets (Table 2), concerns around the markets freezing, and further tightening credit conditions, were likely additional factors the Committee considered. Add rhetoric around peak earnings as further reason to pause.
Table 1: Risk assets rebound in 2019
Table 2: Deal Supply
Inflation—Given inflation concerns are not currently present, as the most recent reading of the core personal consumption expenditure price index is 1.9% (Chart 1), the Fed believes it has the leeway to be patient and let the data unfold. Federal Reserve Chairman Jerome Powell stated he, “would want to see a need for further rate increases . . . and a big part of that would be inflation.” Furthermore, members indicated their inclinations to increase the federal funds rate if inflation rises above the targeted threshold. As it relates to the second part of the Fed’s dual mandate, employment has been reasonably strong (Chart 2) with one important caveat; a strong increase of prime-age workers in the workforce during the last two months. Due to this increase, the labor participation rate has increased to 63.2%, which is the highest level since 2013 (Chart 3). This uptick in the labor participation rate would allow for additional economic growth without inciting inflationary pressure.
Chart 1: Despite post-crisis fiscal and monetary stimulus, inflation is not pressuring the Fed to tighten
Chart 2: Unemployment has now fallen below pre-crisis levels
Chart 3: The civilian participation rate may finally be moving higher
Tail Risks—A frequently used tool in the arsenal of the current administration, the increased implementation of tariffs enacted upon trade partners of the United States, is a threat to global growth. These tariffs have been wide-ranging, and have included Canada, Mexico, EU partners, and most notably, China. The largest uncertainty remains with China and the unknown downstream effect this type of policy may have on two of the world’s largest economies. Across the pond, uncertainty reigns as the United Kingdom continues to sort out Brexit. While markets appear to have some Brexit fatigue, at this point, risk to the downside may outweigh benefits from a soft Brexit.
What Do We Think?
Given the Fed’s position on data dependency and the anticipation of no rate hikes in 2019, market participants are balancing the actions of the Fed, which now seem supportive of risk assets, against the reasons for the Fed’s stance, which would indicate broader weakness to global growth than some expected. Barring adverse outcomes from Brexit or tariff discussions, and assuming inflation continues along a relatively benign path, economic growth and market volatility should be the primary inputs in determining Fed policy during the next year. Employment, manufacturing, retail sales, and housing inputs coupled with yield curve, credit spreads, and equity volatility data should provide a better sense of the Fed’s next move.
While it is not possible to project with certainty future Fed policy, we believe the Fed will exercise caution to avoid further disruption of the delicate balance of policy and prices. Given the Fed’s stance, which is now more reactive, risk investors will probably be better off if the Fed’s next move is a rate hike, as economy and markets would suggest strength as the culprit. We continue to closely monitor capital markets and economic activity, and we urge readers to follow a similar path and watch the data.
(1) CME Group FedWatch Tool as of March 2019
(2) Steelman, Aaron. “The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea.” Federal Reserve Bank of Richmond, December 2011.
(3) Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, March 2019.” Federal Reserve, March 20, 2019.
(4) “ECB staff macroeconomic projections for the euro area, March 2019.” Research and Publications. Macroeconomic projections European Central Bank, March 7, 2019.
(5) Bloomberg News. “China Lowers Growth Target and Cuts Taxes as Economy Slows.” Economics. Bloomberg, March 4, 2019.
Aggregate is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, which is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
Bank Loan is represented by the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged-loan market.
The core personal consumption expenditures (PCE) price index measures the prices consumers pay for goods and services without the volatility caused by energy and food prices.
Corporate is represented by the Bloomberg Barclays U.S. Corporate Index, which includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements.
High Yield is represented by the Bloomberg Barclays U.S. Corporate High Yield Index, which represents the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market.
Investment Grade is represented by the Bloomberg Barclays U.S. Corporate Bond Index, which represents publicly-issued U.S corporate, investment-grade securities, and specified foreign debentures, and secured notes that meet the specified maturity, liquidity, and quality requirements.
The S&P 500® index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
About Pacific Asset Management
Founded in 2007, Pacific Asset Management specializes in credit oriented fixed income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC registered investment adviser and a wholly-owned subsidiary of Pacific Life Insurance Company. As of March 31, 2019, Pacific Asset Management managed approximately $11.3 billion.
Important Notes and Disclosures
This commentary represents the views of the portfolio managers at Pacific Asset Management as of April 3, 2019 and are presented for informational purposes only. These views represent the opinions of the portfolio managers and should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
All investing involves risk, including the possible loss of the principal amount invested.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Pacific Funds and Pacific Asset Management are registered service marks of Pacific Life Insurance Company (Pacific Life). S&P is a registered trademark of Standard & Poor’s Financial Services LLC. All third-party trademarks referenced by Pacific Life, such as S&P, belong to their respective owners. References of third-party trademarks do not indicate or signify any relationship, sponsorship, or endorsement between Pacific Life and the owners of referenced trademarks.