The Federal Reserve Open Market Committee (FOMC) recently held its last meeting of 2019, and the first meeting since June where it did not cut its Fed Funds target rate, leaving that rate in the 1.50% to 1.75% range. This decision was expected based on prior Federal Reserve (Fed)-speak telegraphing a “wait and see” approach to assess the impact of the three cuts this year.
Since the fourth quarter of 2018, we expected that the Fed would deliver three rate cuts in 2019 and a possible additional cut in 2020, versus up to four projected Fed increases in 2019.
In one of the most substantive changes to the FOMC’s statement, they removed a reference to “uncertainties” to the economic outlook. We believe that one of the key uncertainties was the trade agreement with China. However, as we write this on Thursday December 12, the U.S. and China have agreed in principle to a Phase 1 deal. The meeting also marked the first unanimous FOMC decision since May. This outcome indicates the committee’s proclivity to remain on hold for the foreseeable future, and Fed Chairman Powell’s press conference reinforced that notion. Perhaps the unanimity demands caution as a unanimous Fed has often presaged the economy to move in a different direction.
While almost no one expected a change in the rate target from this meeting, the market was more focused on communications regarding future policy, particularly the members’ “dot plots” which indicate each committee member’s projections of where Fed Funds will be at the end of each subsequent year. Four of the members forecast a hike in 2020, while 13 of them expected rates to stay on hold. However, going out past next year, one hike is reflected for 2021, while the median 2022 dots show two hikes over the next three years.
Perhaps the future hikes shown by the dot plots reflect a degree of optimism from committee members that the economy is on solid footing. However, the dot plots have often been a poor predictor of future policy and have frequently differed from market expectations. Even after today’s trade deal, the Fed Funds futures market is pricing one additional cut in total, with about an 80% probability that it occurs in 2020. Prior to the trade news, the market was pricing in a full cut next year, and a slight probability of an additional cut thereafter.
The outlook has improved markedly since August. One model that we follow is that of the NY Fed, which then was indicating a 37.9% probability of recession over the next year while several leading indicators were showing substantial weakness, particularly in the manufacturing sector. The markets reflected this outlook as most Treasury yields declined more than 40 basis points that month and the (2-year to 10-year) yield curve inverted.
However, since then the NY Fed model has fallen to a 24.6% recession probability. With the substantial decrease in that model and the trade issue behind us, we believe that a recession will most likely be averted in 2020. We expect that consumption will be the main driver of growth, as a very strong labor market has kept household balance sheets healthy. With this in mind, we believe the Fed will remain on hold for the foreseeable future. If the Fed is on hold and the economy continues stays on course, rates are likely to rise by 2021, the yield curve will steepen, and volatility should decline as uncertainty is removed.