Risk assets have bounced back this year after a dreadful finish in 2018, with a big assist from the US central bank. But are markets overlooking the potential for problems down the road?
A lot seems to be going right in 2019. Policy stimulus appears to have preempted a sharper slowdown in China, and US-China trade talks are ongoing, though agreement remains elusive. Eurozone growth rebounded in the first quarter, while the US economy and corporate earnings have held up well, pushing the S&P 500 Index to an all-time high.
Most important of all, though, was the major course correction by the US Federal Reserve, which went from raising interest rates in December (and signaling more to come) to indicating in March that it expects to stay on the sidelines for the rest of this year—and next.
The market seems to have decided that the Fed took its foot off the monetary brake because it worried that the US economy was slowing. That would explain why so many strategists still think the Fed will cut rates by year-end.
We see things differently. As my colleague Eric Winograd put it in a recent blog, “the Fed didn’t stop hiking interest rates because there’s a growth problem—it stopped because there’s an inflation problem. Simply put, inflation has gone missing, and the Fed is worried about it.”
Low inflation sounds like a good thing. But if it persists, it can lock an economy into a deflationary spiral with falling prices, slowing demand and rising unemployment. Japan’s experience over the past few decades is a case in point. The takeaway here is that the Fed is likely to let the economy run hot for long enough to push inflation higher, even if economic growth remains solid.
Is the Fed Playing Kick the Can?
Here’s the good news: the epic rebound in risk assets is likely to last for a while. US yield curves have steepened and returns from risk assets—high-yield bonds, emerging-market (EM) debt and so on—have soared since January. The market’s dovish reaction to the Fed’s shift is understandable, but we still think rate cuts are unlikely.
The Fed’s about-face on rates may be a green light for risk-taking today. But it delays the eventual reckoning that comes with the end of the economic cycle. We don’t expect that reckoning this year. When it does come, though, it may be painful for investors who have taken on too much risk. What’s more, the Fed doesn’t have as much firepower to fight it. The European Central Bank, which recently said it will keep rates at zero until at least 2020, has even less.