The Long Pause

By Charlie Bilello

The Federal Reserve hiked interest rates for the 9th time this month, bringing the Fed Funds Rate up to a range of 2.25% – 2.50%.

The move should have surprised no one, as the bond market was pricing it in for some time. Over the past 3 years, at every FOMC meeting where the market expected a Fed hike (9 meetings), they got one.

While many were critical of the move, a hike was necessary for the Fed to maintain its credibility. They had been signaling a December hike for months, and had they refrained many would have viewed it as a sign of weakness, bowing to political pressure from President Trump.

But that is the past. Going forward, the every-other-meeting hiking routine is over. While the Fed is still projecting 3 more interest rates hikes in 2019 (down from 4 at the September meeting), they are unlikely to meet this target. Instead, a long pause awaits us.

Why? 6 Reasons…

1) Inflation expectations have plummeted, with 5-year breakevens at their lowest levels in 2 years. The inflationary pressures that we saw earlier in the year are gone, and the Fed now has the luxury of waiting to see if they resurface before hiking again.

2) Global equities are now in a Bear Market, down more than 20%. While the Fed often talks of being “data dependent,” the stock market has long been one of their most important “data” points. In the 2011 Bear Market, the Fed pushed back rate hike expectations (they did not hike until December 2015) and came out with operation twist. At the lows in early 2016, rate hike expectations were again pushed back, and the Fed did not hike until December of that year (only after the equity markets were safely at new all-time highs).

The Fed is subtly sending a similar message today. As the stock market declined over the past few months, Jerome Powell’s definition of “neutral” changed from a “long way from neutral” to “just below” it.

3) Normalization is here. As I wrote back in October, the longest period of easy money in history is over. With the real Fed Funds Rate now at 0.2% (its highest since early 2008), the Fed’s goal of normalization has largely been achieved, lessening the urgency to continue hiking at the same pace. To be sure, a 0.2% real rate is still below the historical median (1.3%), but with inflation expectations plummeting, there is no rush to get back there anytime soon.

4) Credit conditions are tightening, with high yield bond spreads at their widest levels in over 2 years and leveraged loan prices at their lowest level in over 2 years. In the past, the Fed has been reluctant to aggressively hike rates into deteriorating credit markets.

Data Source: FRED.

Data source: S&P/LSTA.

5) The rest of the developed world remains extraordinarily easy. The US Fed is the only major developed country central bank with a positive real interest rate. The European Central Bank and Bank of Japan are expected to maintain negative interest rate policies at least through the end of 2019.

With the US Dollar Index recently hitting a 52-week high, up against most currencies in 2018, the Fed will be in no rush to increase the spread between its more hawkish policies and the dovish policies of its peers.

6) The market (Fed Funds Futures) is expecting no rate hikes in 2019 and a rate cut in 2020. While market odds can change, the Fed is unlikely to surprise the market with another hike as long as reasons 1-5 are present.

And so, a long pause likely awaits us. As to whether market participants should be happy about such a pause, that is unclear. The best case scenario would be for market conditions to improve enough in 2019 for a rate hike to become a viable option again. The worst case scenario would be one in which the Fed starts cutting interest rates, for that would most certainly mean a recession and deeper stock market declines.

When it comes to central bank policy, those imploring the Fed to be more dovish should be careful what they wish for. Once the cycle has turned, easier policies are no panacea. The last two major Bear Markets showed us that much, with both featuring ongoing Fed rate cuts all the way down.

I don’t know what will happen in 2019, but I know I don’t want to see the Fed cutting rates again. A pause that refreshes would be the best outcome, with the next move in the Fed Funds being another hike.

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