Monetary policy is – once again – way too dominating a factor for asset allocation decision making. Global bond yields are tumbling and risk assets have for the most of the preceding months of 2019 been soaring. Both trends have been fueled by central bank intervention.
The most important central bank intervention is the one that the FED has orchestrated. And without the 180 degrees turnaround in the expected path for Fed fund rates on 12 and 24 months horizons, global and US risk assets would most likely not have performed so strongly in H1 2019.
After a 25 bps hike of the FED Fund target rate December 19, Fed officials already in January signaled that the FED would likely be on hold. A few months later FED indicated that a rate cut was a plausible scenario. Last month the central bank cut its key interest rate by 0,25%.
For the rest of 2019, a crucial question for investors will be how much policy easing from the US central bank investors should expect? A bearish FED could spur volatility.
If we look at a proxy for FED’s policy – a Taylor Rule – FED should not even have started to cut interest rates. Our Rule is based on the following input : Output gap: +0.50%, Core Consumer inflation: 2%, R* – The long term balancing real interest rate at 0. This add up to a 2.5% Fed Fund rate (as also show in chart below). Fed did last month cut the rate to 2.25(!).
Although you can ask yourself whether Powell’s FED is in fact following Taylor, FED did signal hesitation when lowering the key rate on 31 July. At CAP, at least, we do not start to factor in a series of cuts from FED. Current data on inflation and the job market is simply too strong. On top of that, if Trump makes peace with China on trade, market bets on recession and Fed easing cycle could very well revert.
Don’t count on FED to make H2 as good for performance as H1.