The Fed delivered an overall dovish message at its June Federal Open Market Committee (FOMC) meeting yesterday that underscored its commitment to fully support the post-pandemic recovery and, in our view, signaled an effort to forestall a potential quantitative easing (QE) taper tantrum and an acceleration of rising rates that risks jeopardizing the recovery in risk asset prices.
As anticipated, the Fed Funds rate was left unchanged at 0% - 0.25% with also no change in the forward guidance “to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The Fed’s dot plot shows the policy rate remaining unchanged at current levels from 2020 to 2022, with only two participants signalling hikes in 2022. The median expectation of the long-term Fed Funds rate remains at 2.5%. As Powell stated succinctly in his press conference: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”
The Fed also strengthened its message on QE versus its statement in April, and now says it will “increase its holdings of Treasuries Securities and agency residential and commercial mortgage-back securities at least at the current pace to sustain smooth market functioning”, with the current pace being $80 billion of Treasuries and $40 billion of agency MBS per month.
The Fed’s view of the economic situation remains mostly unchanged versus April. In the Summary of Economic Projections (SEP) released for the first time this year, the Fed forecasts GDP growth at -6.5% for 2020, +5% for 2021 and +3.5% for 2022. Unemployment is forecasted to fall to 9.3% in 2020, and then further to 6.5% in 2021 and 5.5% in 2022. These forecasts characterise the Fed’s overall view of a short recession with a long drawn out recovery path.
The SEP also forecasts that inflation will fall short of the Fed’s 2% target over the next three years, with the Fed’s preferred measure of inflation – the core personal consumption expenditure (PCE) index - rising only 1% in 2020, 1.5% in 2021 and 1.7% in 2022, reflecting the Fed’s thinking that the pandemic will create disinflationary pressures. This implies a bias towards policies ahead to kickstart inflation expectations towards the long term 2% target.
The market did not expect anything less than a resolutely supportive message from the Fed, and the key areas of the June FOMC outcome were broadly in line with expectations, in our view. In the direct aftermath of the Fed meeting, the reactions across the risk asset landscape were muted and mixed: equities pared gains slightly, but the Treasury curve showed a mild bull steepening as yields rose 2 to 4 bp across the curve.
Overall, we see this outcome to be well calibrated by the Fed and would help the committee bridge to the September meeting, as it takes more time to assess the trajectory of the recovery and evaluate how forward guidance should evolve over time with the potential adoption of yield curve targets – two policy tools that markets are focused on but received little information at this meeting.
The Fed’s action to effectively end the tapering of its market functioning QE by committing to a pace of monthly purchases at its current level or higher forestalled the scenario of a potential taper tantrum in financial markets, which could derail financial conditions as the post-pandemic recovery enters a delicate period with uncertainties related to second waves of infection and the upcoming US Presidential elections still looming large in the background.
The Fed’s message on the path of rates, the tilt to disinflationary risks and the potential employment of forward guidance with yield caps generally affirms a world with lower-forlonger rates, which underpins our view that the search for yield will continue to be a powerful market driver as we maintain an overall overweight view in fixed income in our asset allocation strategy.Disclaimer applicable to recommendation
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Version: March 2020