Co-Head of Global Bonds Nick Maroutsos discusses why he believes the Fed’s decision to leave rates unchanged at its January meeting should support the positive environment for stock and bond markets in 2020 and why – should markets slip – the Fed will rush to catch their fall.
- The US Federal Reserve (Fed) announced that it is keeping its benchmark interest rate range unchanged at 1.50% to 1.75% saying the current level is “appropriate to support sustained expansion of economic activity.”
- The decision was consistent with our view that the Fed will remain accommodative and is more likely to lower interest rates further than raise them.
- An accommodative Fed supports financial markets. As such, we expect stock and bond returns in 2020 may look a lot like 2019, just at lower total returns.
The US Federal Reserve Open Market Committee (FOMC) voted unanimously on 29 January to keep the benchmark interest rate range unchanged at 1.5% to 1.75%, saying the current level is “appropriate to support sustained expansion of economic activity.” This is the second consecutive meeting at which the FOMC opted to keep rates unchanged, and the decision was widely expected by financial markets. It is also consistent with our view that the Fed will remain not just accommodative but is more likely to lower rather than raise interest rates.
The Fed did raise the interest rate they pay on “excess reserves” – the rate they pay to hold banks’ reserves – to 1.6% from 1.55%. While it is an effective tightening, it is a minor adjustment, serving to help nudge the prevailing interest rate closer to the middle of their intended 1.50% to 1.75% range from the lower end at which it had been lingering.
More cuts before a hike
As the US economy continues to show signs of recovery from its 2019 weakness, the need to lower rates further has indeed subsided. The Fed’s three rate cuts in 2019 are still working their way through the economy, and fears of a drag on growth from international trade tensions have subsided. However, new threats to economic growth are more likely than the conditions that could prompt a rate hike, such as above-trend US economic growth, a surge in global economic growth or a spike in inflation.
Indeed, Fed Chairman Powell clarified in his remarks that the small change in the FOMC’s wording on their inflation target – changing their aim from bringing inflation “near” their 2% target “to” their 2% target – was meant to clear up any confusion about whether they would be content with inflation remaining near, but below, 2% (Chairman Powell clearly stated that they would not be). Yet it remains unclear what conditions will succeed in pushing inflation higher, particularly as structural factors such as technological advances are working to keep it low. Ultimately, more rate cuts may be necessary.
The Fed’s accommodative stance, in our view, is also likely to persist as the Fed has firmly established its reputation for being accommodative to the needs of financial markets. The rate cuts in the second half of 2019 calmed nervous markets, allowing US credit markets (including the high yield market) to perform well. Now, the simultaneous needs of the US corporate sector to finance itself and investors’ need for yield are a convenient match that the Fed would like to see continue. If corporate credit spreads widen dramatically, or US equities see a sharp correction, we believe the Fed would intervene to support the markets. This is not to say we think it is likely the US economy is at risk of a recession, only that we expect markets would anticipate recession and that the Fed will respond to the markets and remain accommodative.
Accommodation supports markets
The Fed's decision, in our view, supports the positive environment for stock and bond markets in 2020. Improving global growth buoys assets, and while US equity valuations are relatively rich, the US economy is stable and sentiment among investors remains bullish. In our view, asset classes in 2020 could well shadow 2019, with positive total returns, just at lower levels. US corporate credit market risk looks the most asymmetric given its historically tight spread levels, reminding us of the critical importance of security selection. But should markets slip, we expect the Fed will rush to catch their fall.