Head of Macroeconomic Research
Summary: The December FOMC meeting was not a game-changer. Interest rates were left unchanged and the Fed reiterated its view that the economy is on track. Recent developments in the repo market were a big theme during the Q&A session.
As widely expected by market participants, the Fed voted unanimously to leave interest rates unchanged at the December FOMC meeting – the Fed funds rate stands in a range of 1.5-1.75% and the interest rate on excess reserves remains at 1.55%. The biggest change in the FOMC statement was the inclusion of the mention that “the current stance of monetary policy is appropriate” to sustain expansion of economic activity, strong labor market conditions, and inflation near 2%. The statement also removed reference to “uncertainties” regarding the outlook. During the press conference, Chairman Powell especially highlighted that some uncertainty around trade would be removed from USMCA (the agreement reached on Nafta trade deal replacement has been approved by Democrats in Congress).
In-line with the rate pause, the Dot-Plots are collapsing and signal no action in 2020. Like in the September projections, the Fed still sees one hike in 2021 and one hike in 2022 and reiterates its data-dependent approach adding that not a single factor influences monetary policy.
One of the most interesting aspects of the FOMC meeting was the release of the latest Summary of Economic Projections. GDP and inflation forecasts were unchanged and are aligned with the market narrative (inflation under 2% and lower growth), but unemployment rate for 2020 was cut to 3.5% - a level where we see slack in the labor market - versus a previous forecast at 3.7%.
To sum up, the FOMC considers the US economy is in a good place, and monetary policy is positioned well, unless something unexpected happens.
Discussion on the latest developments in the repo market
One of the biggest themes during the Q&A session was the recent developments in the repo market and the growth of the Fed's balance sheet. In less than three months, 2019 Quantitative Tightening has been completely erased due to the turmoil in the repo market.
Chairman Powell was consistent with his previous statements. He confirmed he is confident regarding the evolution of the repo market and mentioned the positive effect of the Fed intervention. However, he added that “standing repo facility is something that will take time to evaluate”.
He indicated that the market has been functioning well in the last couple months and that current pressures are manageable.
This view is not shared by all market participants that see rising costs, with repo rates now at almost 4%, as a warning signal indicating that the monetary transmission mechanism is broken.
Some market participants also expect that difficulties will increase in year-end, which is not “unusual” at this period of the year, as acknowledged by Powell. He clearly let the door open, at least in the short-term, to more purchase of securities if necessary.
Looking ahead
Tonight’s meeting does not change our view on the Fed. We think that the Fed is still too optimistic about the outlook. We see that the likelihood of a rate cut during H1 2020 remains high as US growth momentum is weaker than a year ago and downside risks are still elevated (trade war, China’s slowdown, funding issues etc.). We expect that the US manufacturing sector will stay weak in coming months, which could force the Fed to reassess the balance of risks.
On the top of that, funding issues in the repo market are still cause for concern. The Fed has already injected $350bn, but total market support is likely to exceed $500bn in coming months. We are much more worried about what is happening and what it signals regarding monetary policy transmission than the Fed. We will know more about the extent of the problem tomorrow, as the Fed is expected to announce its 2020 calendar offerings. We have little doubt that “not QE” is likely to last longer than most FOMC members expect.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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