There was not much a surprise when the Fed announced on 20th March that it would maintain status quo on rates. That means; the rates would be held at the current level of 2.25%-2.50%. In fact the CME FEDWATCH, which gauges probability of a rate hike based on Fed futures pricing, was already assigning a 99% probability to the status quo. Hence the markets were almost resigned to a status quo on rates. But what really surprised the markets was the starkly dovish tone of the Fed.
Dovish from December
After four rate hikes in 2018, the Federal Reserve had hinted at a possible 2 rate hikes in the full year 2019. That was supposed to keep the average rates relatively lower than the pre-crisis levels but that was understandable. What really surprised the market on 20th was the clear signal coming from Jerome Powell that there would not be any further rate hike in the year 2019. The rate hikes began in December 2015 and it was predicated on rising inflation, improving growth and solid labor data. A lot has changed since the trade war began in the middle of last year. The punitive tariffs imposed by the US and China now only slowed down these economies but also threatened to impact other global economies too. In fact, IMF has already downgraded global growth by 40 basis points. Weak growth would mean weak oil prices and therefore weak inflation.
Data points falter
There was a clear faltering in key data points. The GDP growth was downsized from 2.3% to 2.1% and could trend lower. Secondly, the unemployment rate had gone by 20 bps to 3.7%, which was again a cause of worry as jobs had actually been lost as an outcome of the internecine trade war. But most important was the expectations of the members of the FOMC. At the beginning of the year, 11 members had estimated two rate hikes during the year but by March that number had come down to just 2 members. And the CME FEDWATCH has also started assigning probability of a possible rate cut during the second half of the year.
Liquidity could be the big story
Back in 2013, when the Fed balance sheet reached $4.50 trillion, it started to taper. Fed stopped fresh issues of bonds but kept rolling over existing bonds, so the balance sheet stayed at the same level till 2017. Effective October 2017, the Fed has started to reduce the balance sheet by $50 billion per month. With nearly $800 billion of liquidity gone, the tightening was beginning to show. Now the Fed has indicated that it may stop reducing the balance sheet size. That may be good news for global liquidity, especially for risky assets like emerging market equities, which are driven by liquidity. That could be the big take-away for Indian markets! ©