Fed’s dovish tilt and market implications

US FOMC has taken one more step toward signalling an end to rates normalisation. We think the Fed’s implicit signal is that it over the near term it may well take a relaxed view about inflation.
Taimur Baig, Philip Wee, Eugene Leow21 Mar 2019
  • The economic projections made by FOMC members are lower than they were just a couple of months ago
  • We expect no further Fed rate hikes both in 2019 and 2020
  • The Fed’s relaxed view about inflation could cause the yield curve to steepen eventually
  • The USD has sold off lately, but we don’t see sustained dollar weakness ahead
  • If developments in China stabilise global demand, the Fed may seem as having blinked too early
Photo credit: AFP Photo

Conventional wisdom in the markets used to be “don’t fight the Fed.” However, over the past decade or so, the US central bank has repeatedly scaled back its expectation of growth and inflation, and displayed acute sensitivity to the performance of asset markets. Perhaps the Fed now believes “don’t fight the markets.”

The March 20 FOMC decision reveals a bit more dovish view of the growth and inflation outlook, but they are not that material. After all, the economic projections are only 0.2% lower (2.1% vs 2.3% made in December) and even more modest for inflation (1.8% vs 1.9%). But between the line, we are picking up a more profound signal—which is that despite strong wage growth and rebounding commodity prices, the Fed will take a relaxed attitude if inflation were to pick up again. If true, this would mark a major departure in the monetary policy stance. We think that Fed communication will be increasingly focused on this area; having undershot its inflation target year after year, a bit of overshoot will be overlooked by the Fed in 2019 and 2020.

In our rates section, we consider the implication of this line of signalling. Right now, the fixed income market is rallying, but could the long-end eventually sell off as inflation bottoms, fiscal deficit remains large, and demand for long duration assets wane? We think this is quite possible, and not at all priced by the market.

Fed’s dovish move extends beyond dot plots. Strikingly, the Fed has made clear that the pace of balance sheet normalisation will be slowed. The cap in monthly redemptions of treasury holdings will go to USD15bn beginning in May (from USD30bn). This and other tweaks will leave the Fed balance sheet steady at around USD3.5trln later this year.

These measures are going to provide crucial support to emerging markets, in our view. Liquidity conditions and cost of financing, both of which were sources of major headwind last year for EM rates and credit, will fade. But the eventual steepening of the US yield curve that we are envisaging could complicate the long-term funding picture eventually.

These market pleasing developments have fuelled rallies in EM assets already, but how sustainable is that? We note that both China and Europe have several idiosyncratic headwinds in play, which form negatives for their markets and economies. For China, these include the negative spill-over from its debt overhang and weak domestic sentiments. For Europe, they range from Brexit to complicated politics in France, Germany, Italy, and Spain. Hence, we are not expecting a sharp selloff in DXY.

We feel that Western central banks still do not fully appreciate the impact of China on their growth and inflation outlook. Perhaps the reaction function of policy makers should give higher weight to China’s demand and price conditions, as they seem to be the best early warning indicators of the global cycle. With that mind, If the ongoing fiscal stimulus in China and positive developments in the China-US trade talks stabilise global demand and sentiments, the Fed may come across as having blinked too early

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Taimur Baig, Ph.D.

Chief Economist - G3 & Asia

Philip Wee

FX Strategist - G3 & Asia

Eugene Leow

Rates Strategist - G3 & Asia

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