The Federal Reserve (Fed) delivered a surprise to market participants following its two-day meeting. Rates were kept unchanged, which was widely expected, but median estimates for policy rates now indicate that no rate hikes are anticipated in 2019 (down from two), with one rate hike expected in 2020 (unchanged). Economic projections were also downgraded, with slightly lower growth and slightly higher unemployment expected. After the announcement, bond yields fell while major equity indices rallied off the day’s lows. Riskier corporate bonds and other interest-rate sensitive assets (such as real estate securities) rallied, reflecting a subdued outlook for interest rates. In addition, the U.S. dollar fell, which supported non-U.S. asset prices.
In a reversal from the December meeting, with monetary policy seemingly on “autopilot,” it is apparent that the Fed will take a more data-driven approach to future rate increases and has no plans to change rates for some time. Only six of the 17 Committee members expect rates should be higher by year-end, compared to 15 members at the December meeting. Chairman Powell repeated recent comments that the U.S. economy is “in a good place,” but he has previously noted crosscurrents in the form of slowing growth outside the United States and policy risks, such as trade negotiations and Brexit. Economic growth projections were slightly reduced while unemployment expectations were slightly increased. Expectations for core inflation (inflation not including volatile food and energy prices) remained unchanged. Based on the Fed’s release today, we are shifting our base case to be in line with the Fed’s estimate for no rate hikes in 2019. However, we still view risks, on balance, as skewed toward a rate hike rather than a rate cut. Inflation remains muted, which would likely need to rebound before the Fed would increase rates.
The Fed also announced plans to slow the reduction of its net balance sheet in May and anticipate ending the reduction in September, settling at a level “a bit above $3.5 trillion.” It will allow the mortgage portfolio to continue to mature, reinvesting maturing principal in U.S. Treasuries. We anticipate these actions will remain a slight net headwind to agency mortgage-backed securities and a tailwind to U.S. Treasuries. The Fed’s plan to retain a large balance sheet is driven by the nuances of maintaining control over short-term interest rates via excess reserves in the banking system, rather than a desire to maintain stimulative policy.
We remain focused on the trend in economic data in the United States and globally. Our analysis indicates the global economy is on a path of a re-synchronized slowdown. Odds of a recession remain modest globally and low for the United States. We are maintaining our balanced assessment of risks between stocks and bonds, which is guiding our recommendation to hold stock and bond allocations close to long-term strategic target allocations. This reflects higher levels of volatility across global equity markets and higher policy rates in the United States relative to year-ago levels. Within bond portfolios, we favor below-benchmark maturity profiles to reduce price risk in the event of rising bond yields, and as a reflection of the limited incremental return for extending maturities. We advise that bond portfolios be primarily comprised of high quality bonds to provide adequate portfolio diversification, which is supported by somewhat elevated valuations in riskier credit categories such as high yield corporate bonds and emerging market debt.
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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their unique situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way.
Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in mortgage-backed securities include additional risks that investors should be aware of, such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).