The US Federal Reserve surprises the market again.
The Fed is no longer expected to raise rates this year, nor next year in our view. We revise down our 12-month bond yield targets to 2.70% for the 10-year and 2.40% for the 2-year.
Yesterday's announcement
The US Federal Reserve exceeded all expectations. It said that it would not raise rates this year, while at the end of last year it was planning two rate hikes for 2019. It does, however, keep its intention to hike rates one last time in 2020, but there is less conviction on the part of voting members. 2020 would therefore mark the end of the rate normalization, with the Fed funds rate at 2.75%.
As for the balance sheet, the Fed had committed, for several years, to reducing it automatically and on a scheduled basis. It now expects to gradually stop reducing the size of the balance sheet from May, with the aim of ending in September.
The Fed slightly has revised down its economic projections and is forecasting lower growth for this year. The labor market, however, is expected to remain dynamic. Inflation is expected to remain at around 2%.
So the Fed has changed its stance. It is focusing on macro-economic data and financial conditions. It seems that only a resurgence of inflation will prompt it to be more restrictive.
The markets have abandoned the idea that the Fed will raise rates this year and is already pricing in a rate cut next year, in the context of an economic slowdown.
The market reaction
The market reaction has been quite violent so far. The 2-year bond yield has shrunk by more than 5 basis points and is now trading at around 2.38%. The movement has been more pronounced on the 10-year yield, which fell to 2.51% yesterday, i.e. a drop of 8 basis points.
In the equity markets, the reaction has been quite mixed, amid monetary easing and fears of an economic slowdown. The S&P 500 index recovered temporarily yesterday, but closed the session in the red (-0.29%), penalized by financial stocks.
The dollar depreciated against the euro from 1.135 to 1.144 yesterday.
Our view
We no longer expect an increase in the Fed funds rate for this year, so we abandon the idea of a last rate hike in June. The monetary tightening cycle stops here, in our view, with the Fed funds rate at 2.50%.
We are lowering our 12-month bond yield targets. The 2-year yield is likely to remain stable, at around 2.40%, if the Fed provides no impetus. The rise in the 10-year yield is being undermined and we are decreasing our target from 3.25% to 2.70%. The yield curve slope between the 10-year yield and the 2-year yield is therefore flatter, in line with the idea that the US is approaching the end of the cycle.