David Roberts

Has the Fed taken away the punchbowl?

David Roberts

Federal Reserve

The US Federal Reserve left key interest rates unchanged at its meeting this week and during his subsequent press conference, Chair Jerome Powell reiterated his view the next move is entirely data dependent and could be up or down.

Even this very benign statement instantly caused US equities to fall more than 1%, short-dated US bonds to drop and the dollar to rally, and inflation-protected securities to underperform conventional ones. All of these happened because the market had become too bullish and chosen to ignore Powell’s previous comments that he intended doing nothing to rates for now: it suited risk buyers to believe the Fed would be bullied by President Trump into unnecessarily cutting rates.

The decade-old risk rally has been built on the back of free money; the year-to-date rally, meanwhile, has relied on a continuation of that state of affairs, with the Fed U-turn on rates turning a late 2018 sell off into an early 2019 bull stampede.

Each of those three immediate reactions suggest the market is starting to take the Fed at its word: the economy is doing fine and there is no need at present for further stimulus. None of that means we are set up for a big reversal and, indeed, the Fed’s lack of action shows its confidence in the economy, something from which investors can take heart.

Wednesday’s mini correction is not necessarily the start of something more severe but rather the product of markets that have run a little too fast and, at the very least, should be pausing for breath. Or to put it another way, risk assets and core bonds are back to expensive levels and we either need a proverbial crystal ball or to study incoming economic data to justify pushing prices in either direction from here.

Does this change anything? Possibly: as Powell says, it all depends on data. The market is set up for very benign scenarios of modest growth and inflation, with central banks to help out if anything bad happens. That may well still be the case and is close to our core scenario. 

Our Strategic funds do own inflation-protected and short-dated bonds but have room to add more. We have also dialled back the credit risk, expecting recent high prices to fade, largely on the back of a less dovish Fed. 

On Wednesday morning, investors thought the Fed was prepared to cut rates and risk inflation to support asset prices, regardless of the economic need to do so. Today, that does not appear to be the case: the Fed knows the economy despite what President Trump thinks is not the stock market. Taking a risk with inflation and spurring growth to boost asset prices when the economy is already doing fine is not prudent.

And what about funds and markets? Small sell offs in short bonds and equities are understandable, as are modestly lower inflation expectations, and that is what we have seen so far. There is little reason for markets to move much from here unless incoming data dictate otherwise or investors decide to take profits at elevated levels after the great recent run. We would rather see a little more volatility than we have of late and are well positioned if that is the case. 

To be clear, though, this week’s meeting should actually calm volatility and have us all data watching. That’s fine too, it just reduces the probability of further excess returns for now. The Fed is not taking away its proverbial punch bowl, it is just urging us all to drink a little more responsibly.

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Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


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Friday, May 3, 2019, 8:50 AM