Central bank dovishness returns

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Global markets extended their gains in February, with the pause in monetary policy tightening that the Federal Reserve had hinted at in late January a major driver next to the pro-growth measures by Chinese policymakers [1]. What caused the US central bank to hold off?

  • Sharp bounce on Fed policy U-turn follows steep losses
  • Fed had allowed financial conditions to tighten on autopilot

The market’s response to what looks like a small U-turn in monetary policy by the Fed is perhaps not that surprising given

  • the sharp losses sustained in December
  • investor concerns over the current stage of the economic cycle and the prospects for growth
  • the worries about quantitative tightening by leading central banks and the impact on asset allocation.

What does the Fed news mean for markets going forward?

We think there are several aspects to understanding the Fed’s move.

US data and the broader global growth backdrop has weakened and in this context, the Fed’s interest-rate policy had already shifted into restrictive territory. So, after already tightening policy for a while, a pause seemed to be justified given the soft patch in the economy.

Historically, volatility often picks up when the Fed tightens policy (or is seen to tighten policy) ‘too quickly’ late in the economic cycle. The sharp market correction late in 2018 and the associated tightening in financial conditions probably gave the Fed food for thought. In fact, in many ways, this pause reminds us of 2015/2016 (for more, also read this article on the similarities and the differences) when equities skidded and the Fed was ‘forced’ to take its foot off the pedal, raising rates only once in 2016.

Furthermore, we feel that the Fed’s approach to trimming its balance sheet was perhaps the real culprit. The central bank had been unwinding its asset purchases under quantitative easing (QE) on ‘autopilot’ regardless of the incoming data.

Exhibit 1: Unwinding the Fed’s balance sheet – autopilot approach is the real culprit

(equity market volatility starts in earnest only as the balance sheet starts to shrink)

Central bank dovishness returns

Source: Bloomberg and BNPP AM, as of 28/02/2019

Either way, we now believe the hurdle for a renewed shift in US central bank policy is high. Equally, we think a move towards renewed easing is also unlikely, so the current pause by the Fed could last several months. This is an important development for global markets.

While the Fed’s policy pause has grabbed the attention of markets in the here and now, we believe fundamentals will ultimately have to become the main driver again.

As we have often shown, quantitative easing by the leading central banks significantly propelled markets in recent years, and in some episodes even when there were no positive fundamentals. In fact, many of the QE years saw equity market multiples expanding, without earnings growth being strong. We now foresee a renewed focus on the fundamentals in the medium term.

This is an extract from the asset allocation monthly by the MAQS team at BNP Paribas Asset Management.

For the full version, click here >

For more articles on market events, click here >

[1] For a comment on the latest pro-growth measures by the Chinese government, click here >

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Views expressed are those of the investment committee of MAQS, as of March 2019. Individual portfolio management teams outside of MAQS may hold different views and may make different investment decisions for different clients.

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