As 2019 began, a host of factors were contributing to a growing sense of pessimism regarding the global economy and capital markets. Two macro factors have certainly been top of mind: the Federal Reserve’s tightening of monetary policy and the escalating trade tensions between the U.S. and China.
Of course, a few recent developments have served to dispel some of the worst of the doom and gloom that had gripped markets by the end of 2018. The Trump administration has been singing an upbeat tune during the past few days, signaling that trade talks in China may result in something tangible. At the very least, markets are somewhat less terrified of an imminent end to the trade truce hammered out in December.
The Fed has also been walking back its commitment to further interest rate hikes. After rattling markets with a hike in December, rates were kept flat in January. The Feb. 20 release of the minutes from the Federal Open Market Committee’s meeting shows an organization turned even more dovish than previously thought. That could have profound consequences for the economy and financial markets in 2019 and beyond.
A known quantity acting as promised
Fed Chair Jerome Powell has always been considered hawkish when it comes to monetary policy. He was known to butt heads with his predecessor, the supremely dovish Janet Yellen, who proved extremely skittish about even modest interest rate hikes during her tenure. Thus, Powell’s views on rate policy were quite thoroughly documented before he ascended to the top spot at the world’s most important central bank.
Yet, despite being a known quantity, everyone seemed shocked when Powell actually started enacting the monetary policy measures he had spent years advocating. Markets were thrown into turmoil in December after Powell announced another modest rate hike. Defying market expectations, as well as the stated preference of President Donald Trump, the hike sent markets into a relative tailspin, sparking fears that a full-blown bear market might be in the offing.
Politicians contemplate the unthinkable
As a result of his defiance, and the market turmoil that followed the latest tightening, Powell became the subject of political attack to a degree once thought unthinkable. In a remarkable public display of buyer’s remorse, Trump took the nigh-unprecedented step of threatening to fire the Fed chair, or even interfere directly with monetary policy.
The president seems to regret his decision to appoint Powell, but whether he can (or would) try to remove a supposedly sacrosanct official from his position, has yet to be tested. Yet, while such direct interference was once considered beyond the pale for politicians to even suggest, Trump is not alone. Fearing that the end of the long era of easy money could trigger a recession (and thus threaten their electoral prospects), other politicians have broken new ground in criticism of the Fed.
Powell backs down from the heat
As political and market pressure mounted in December and January, Powell and his fellow Fed hawks seemed to wilt. Holding rates steady in January, Powell promised renewed patience, while several regional Fed banks published more dovish rate hike schedules for 2019.
The Fed appears to be considering an even more dovish tack following Jerome Powell’s January climbdown. The FOMC’s latest minutes show commitment to a “patient approach” with regard to future rate hikes, as well as a growing number of voices calling for even more dovish policy.
FOMC cowed by external pressure
The latest FOMC minutes reveal the biggest capitulation to date to the anxiety of financial institutions, as well as to the anxiety of the political class. On Jan. 10, Powell had declared that the Fed would “substantially” reduce its balance sheet, which ballooned in the aftermath of the financial crisis and has remained historically large in the years of loose monetary policy since. Yet, the FOMC is split not only on the need for further rate hikes in 2019, but also on the need to reduce the Fed’s balance sheet with any degree of alacrity.
These capitulations may help shore up market confidence for now, but it may come at the expense of the Fed’s ability to fight future market downturns and recessionary episodes.
A downturn is coming, but when?
Monetary policy is arguably the most powerful tool in such situations, but the prevailing regime of ultra-low rates means the Fed has precious little firepower to call upon. The current expansionary economic cycle is already in a late stage.
While no one knows when a recession might actually begin, the possibility of a downturn in the relative near-term has been growing. Hedge fund billionaire Ray Dalio (Trades, Portfolio) thinks it could be as soon as next year. Others are more sanguine about the near-term outlook. Goldman Sachs, for example, predicts no recession in 2019 and views it as “unlikely to be the case” that it strikes in 2020 either.
Investor perspective
From an investor’s perspective, the Fed’s walking back on interest rates and balance sheet reduction have two principal consequences. From a short-term view, it means the bull market may be stretched out for a while longer, though the renewed volatility is unlikely to dissipate.
From a longer-run viewpoint, investors would be wise to go cautiously. There are hopes the next recession will be a soft landing, but the lack of monetary policy tools could mean even a mild downturn might last a while.
The market waters of 2019 are far murkier than they have been in more than a decade. Be careful of wading too deep, and be ready for a sudden storm.
Disclosure: No positions.
