Federal Reserve Changes Views; Driven by Lower Excess Reserves

Equity investors cheer, but can the new “punch bowl” keep everyone partying likes it 1999?

In our research article, “Outlook 2019: Similarities to 2017, Recession Expectations May be Misplaced”, we provided our views on the Federal Reserve and the potential impact to the U.S. Dollar during 2019. To summarize we stated the following: “We expect the Federal Reserve will have to “blink” in 2019 as investor expectations suggest zero rate hikes compared to the two implied in benchmark rate increases by the committee. Given recent Federal Reserve data suggesting inflation could remain under the targeted ~2% for the longer-term, we don’t see the need for the Fed to proceed with what is perceived as an aggressive rate hike path by investors. Anticipate the potential for the Fed to slow, or “postpone” the unwinding of balance sheet assets. Following strength in 2018, we believe the U.S. dollar will likely trade lower than current December 28th closing levels of ~96 by year-end 2019.”

Based on recent comments from the Federal Reserve, at its recent January meeting press conference held on Wednesday, January 30th, we believe much of our full-year 2019 outlook has already occurred in the first month of the year. While we would love to take a victory lap, we believe investors need to remain nimble in a more volatile investing world. We do not yet see a material change to our 2019 outlook following the significant increase in market valuation during January. Our full-year 2019 S&P 500 target remains ~2,800, which suggests upside from January 31st closing levels (2,704.10) of ~4%. At the beginning of 2019, the upside to our target was closer to ~12-13% based on closing levels for 2018 (2,486).

We believe with the Federal Reserve now in the background regarding investor concerns, the next potential catalyst to push markets higher will likely be a “trade truce” with China. We will provide our outlook when this event occurs, and we have more information to decide its significance to investments. Initially, we see a potential “trade truce” with China as a potential “sell the news event” for early 2019 with potential opportunities for lower entry points during summer and early fall. However, we will provide a more concrete conclusion following any announcements regarding the current trade dispute between the U.S. and China.

The Federal Reserve Changes Policies Dramatically, What Changed Since early October?

In early October, I believe on my birthday in fact, October 3rd, Jerome Powell famously stated in an interview that at current levels we were “well below the neutral rate” for the federal reserve funds rate. The investment markets interpreted these comments to mean the Federal Reserve was likely on auto-pilot with regards to both rate hikes and balance sheet roll-offs. Following those comments, investment markets witnessed significant volatility in both October, and December, of 2018. Shortly after these comments in early October, around mid-November 2018 or so (maybe a bit earlier), Federal Reserve officials, including Chairman Powell, started to signal we were getting closer to neutral on the federal reserve funds rate. Following the January meeting, in which federal reserve fund rates were left unchanged from December meeting levels, the Federal Reserve Banking Committee now communicated that rates were now at neutral at ~2.5%.

We view this as a significant change in Federal Reserve policy during 2019 versus 2018. We now believe the Federal Reserve is likely more in-line with prior investment market outlooks, suggesting zero rate hikes in 2019 vs. the prior two rate hikes during 2019, which was implied by the committee following its December “dot-plot” chart. However, similar to 2018, which likely saw the impact from the four rate hikes begin to appear in economic data during the 2H18, we believe the positive impact of a more dovish Federal Reserve will likely lead to a 2H rally following the conclusion of the recent rally, which roughly began following December 24th, 2018.

In-line with market views, and those we expressed in our 2019 Outlook, inflation does not remain an issue at this time, remaining under the 2% target arbitrarily set by the Federal Reserve Open Market Committee. Chairman Powell noted “muted inflation pressures” at this time in his prepared statement. Given what the Federal Reserve described itself as “muted inflation pressures” we don’t see a need for a similar rate hike path as 2018. The Federal Reserve did note that some positive impact to “muted inflation pressures” occurred from lower oil prices. If the price of oil was to dramatically rise in the next 6-12 months, it could begin to lift inflation closer to levels which may concern some committee officials.

Per the Federal Reserve statement following its January meeting, the committee is reviewing, and now open to, changing the pace of its balance sheet roll-off. The market believed this balance sheet roll-off likely increased the effect of tightening on global liquidity far beyond the impact of just the rate hike increases. This change in tone regarding its balance sheet, and a more flexible outlook was well received by investment markets and likely the most critical commentary regarding potential positive impacts on future equity market returns. As we stated in our 2019 Outlook: “The corresponding unwinding of the Federal Reserve’s balance sheet, now called “Quantitative Tightening” or “QT” in conjunction with four rate hikes, has created controversy regarding how much the actual impact to overall liquidity may be versus simply adjusting for rate increases. This “push back” regarding the current rate hike path laid out by Federal Reserve forecasts has been demonstrated in both the stock market with a historic decline in December, and the bond market with short-term rates continuing to increase while long-term rates such as the ten-year yield seeing declines since mid-year,” we think investors viewed the balance sheet roll-off as equivalent to two historical “rate hikes.” With a clearer view about potential changes in future balance sheet roll-offs, we view prior investor concerns regarding a Federal Reserve mis-step have subsided for now.

Two other notable changes in the Federal Reserve’s view were related to potential risks in the economy and the impact from a global slowdown in growth. In prior meetings, the Federal Reserve refused to, or just didn’t address, any issues from the growing consensus that non-U.S. economies such as China, Europe, along with smaller emerging markets, were impacting global growth and eventually U.S. based companies. In its statement following the January meeting, the committee noted risks to the U.S. economy were no longer balanced and headwinds were occurring from China/Europe slowing, Brexit, Trade, and the recent U.S. government shutdown. Chairman Powell seemed to reference these factors multiple times as a reason for the abrupt change in policy from the Federal Reserve during the Q&A held with the media. Thus, according to the committee and Chairman Powell the case for raising rates has now changed.

Following the change in Federal Reserve policy, which some may say was influenced by recent declines in U.S. equity markets among other issues, have some now calling it the “Powell Put.” This would be defined similarly to how investors viewed potential perceived intervention in Federal Reserve policy by Chairman Powell’s predecessor Janet Yellen when equity markets through a “tantrum.” In his statements, or in an answer to a journalist question, Chairman Powell noted that risks in equity markets were rather high, then saw significant risk-off, but now stock markets more near normal levels.

We view the change in Federal Reserve policy as positive in the near-term for investors, but note the actual impact from this change may be more 2H based. Thus, we believe investors will need to be nimble and become better “stock pickers” in 2019 than just riding the index higher as in prior years.

Excess Reserves, Not Weaker Economy, Likely Driver of Federal Reserve Policy Change

During the press conference following the Federal Reserve’s January meeting, Chairman Powell noted that “ample supply of reserves” is important in regards to a question about the balance sheet. What Chairman Powell was talking about was the Excess Reserves of Depository Institutions. These “Excess Reserves” are deposits which are not restricted by statutory reserve requirements. Often banking institutions utilize these reserves to offer customer loans, invest in development projects, etc. However, since roughly 2015, these “excess reserves” have been roughly cut in half, with a downward acceleration in 2018 as noted in the chart provided by the Federal Reserve (see below). The chart also notes that the shaded areas indicate periods of U.S. economic recession in prior periods. Given current levels per the Federal Reserve sourced chart, we assume the committee was becoming increasingly concerned with the levels of excess reserves. Current levels are only slightly above what was seen during the prior economic recession during 2008/2009 timeframe. By slowing the pace of interest rate hikes and potentially pausing or changing the pace of the balance sheet roll-off, we believe the Federal Reserve is hoping to positively impact excess reserves which in theory should help economic growth. We believe this is the reason for the positive reaction in U.S. equity markets since the Federal Reserve’s January meeting, as the view is based more on a technical issue such as excess reserves at banking institutions and the potential impact on future growth prospects, and not a pause in rate hikes due to a perceived change in the overall economic outlook for 2019.

What’s Changed with Grinder’s 2019 Outlook?

At this time nothing has materially changed from our 2019 Outlook published on January 2, 2019. We see a market which potentially increases single digits from current levels, potentially pulls back, and then re-accelerates in the 2H. While S&P 500 estimates have continued to contract during the month of January, we see economic events such as the shift in Federal Reserve policy, a China “trade truce”, and better than expected forward corporate earnings in the 2H, will lead to a full-year return in the S&P 500 Index (including dividends) equaling ~12-15%. We would be more than happy to be conservative in our outlook for 2019, but at this time we are not making any changes to our prior views.

2019 Grinder Capital