Market Comment: New Fed Chief provides first look at policy stance

News item -

When Jay Powell was appointed Chair of the Federal Reserve last year, investors expected him to provide stability and to continue the very patient policies of Janet Yellen. But circumstances have changed since his appointment, with equity markets just over a nasty speed bump. Powell’s first congressional testimony was therefore under heavy scrutiny.

Powell’s first congressional testimony on Tuesday turned out to be more interesting than we previously thought, not so much for what he told us exactly, but more because of how markets responded to tiny clues in an overall very balanced and nuanced text. Yesterday, he addressed the House  of Representatives and on Thursday, he appears before the Senate. [1]

Markets reacted modestly during testimony

Before the statement, slightly lower yields were indicating that investors were expecting some bias for a more investor-friendly policy from the Federal Reserve. As Powell gave his statement, however, US 10-year bond yields moved up by seven basis points, as investors changed their mind to a more pro-active Fed than previously thought. By the end of the day, however, these yields had returned close to previous-day levels. Fed futures indicated a 5% increase in the probability that the Fed would hike rates four times this year, at the expense of the probability that it would hike rates only twice. The US dollar had strengthened in anticipation of Powell’s testimony and remains at those levels.

Little impact in Europe

US developments had little impact in Europe, where German yields rose by two basis points and  Italian yields even dropped a bit. Investors clearly see that Draghi and the ECB will be navigating quite different circumstances in Europe than Powell and the Fed might be facing in the US.

Mining the text for meaning

Equity markets did not manage to escape the impact yesterday. Stocks moved downwards after the statement  and continued to do so into a bit of an ‘ugly close’ of the US trading sessions on Tuesday. The slide continued into Asian markets in early trading. Powell, who found himself labeled ‘Powell the Hawk’ on Bloomberg by the end of the day, is now suddenly up for a bit of a challenge when he addresses the Senate on Thursday.

The clues in Powell’s text that turned the markets around were probably a combination of several factors, including the statements below.
  1. Powell is ‘personally’ becoming increasingly positive on the US economic outlook and expects this to be reflected in upcoming Fed policy meetings, although he did not want to prejudge any decision still to be made. 
  2. While Yellen supported equity markets by keeping rates low and buying huge amounts of bonds (the ‘Yellen put’), investors got some clues that the ‘Powell put’ could partly be delivered by ‘regulatory reform’ to boost growth. Investors would not like such a change to their old, familiar recipe. Still, they may have to get used to a situation where a more normal economy requires more normal policies. 
  3. Powell described policy rate rule prescriptions as ‘helpful’. This may have caused a (temporary) knee-jerk reaction, as predefined rules are generally associated with higher rates, although Powell continued to favour the existing balanced Fed approach to policy setting. 
We also believe that investors may have underappreciated some remarks that Powell made in his statement:
  1. The recent stock market correction and higher yields are not expected to have a material economic impact and do not require policy adjustments (yet). 
  2. ‘A new wave of investment spending should support higher productivity growth in time’, a factor we think will keep inflation more in check than many investors are appreciating now. 
  3. Powell stated that ‘the balance sheet normalization plan was carefully crafted and rolled out’, not needing any changes. 

Careful approach at the Fed will continue

So far, we are comfortable continuing on a path in our bond portfolio, where we recently started reducing our large underweight in bonds after more attractive yield levels were reached, while maintaining a moderate tilt to more risky assets in general. Powell’s statement has also confirmed to us that we can probably be patient in reducing this underweight in bonds, as we expect the Fed to continue acting carefully.
Chris Huijs, Senior Portfolio Manager, Fixed Income, Global Investment Centre

[1] For additional information, see "Powell bullish on growth, measured on policy," published by Group Economics, 27 February 2018.