Is the Fed giving in to the markets?

As expected by the markets, the Federal Reserve Open Market Committee decided to leave rates unchanged following their March meeting. And the Fed's median Fed Funds rate estimate for 2016 was reduced from December's expectations, moving from an anticipated four quarter-point rate rises to now only two hikes projected in 2016, falling in-line with market expectations ahead of the meeting.

As investors we are told "do not fight the Fed," however, it would appear the Fed's mantra has become "do not fight the market."

Federal Reserve Chair Janet Yellen
Kevin Lamarque | Reuters
Federal Reserve Chair Janet Yellen

Absent from March's statement was any mention of financial market tightness attributing to the pause. With the exception of oil, most financial market stress indicators are back close to their December levels when the Fed began raising interest rates.

However, the Fed's press release stated, "global economic and financial developments continue to pose risks", indicating that the committee remains concerned about financial market conditions outside the United States. Certainly the price of oil ranks high among those risks, but likely so do the experimental negative interest rate monetary policies adopted across much of Europe and more recently in Japan.

The Fed's focus on inflation, or the lack thereof, appeared to be the main driver behind the decision to not hike rates in March. Despite continued improvements in labor market indicators, wage growth has not picked up meaningfully, which is a necessary catalyst for rising inflation and perhaps the biggest concern for policymakers. Wage data will likely remain a focus for the Fed as well as the markets, with direct implications on U.S. break even yields going forward. Interestingly the Fed's median 2016 core PCE inflation projection stood unchanged at 1.6 percent for the end of 2016, even though this measure already rose to 1.7 percent ahead of the meeting.

The Fed was right not to act. While inflation could easily be at 2 percent by the year end, this does not mean inflation will accelerate from there. It did not accelerate much in the last cycle. And it probably won't accelerate much this cycle. It might not be what the text books say, but when was the last time the text books worked?

Despite the more dovish than anticipated tone from the Fed, we still believe economic growth will accelerate modestly from here within the U.S. The U.S. consumer continues to benefit from tighter labor markets, low unemployment and low lending rates, while business spending outside of the energy and mining sector continues to grow. The deflationary impact from lower energy prices is a tailwind for consumers, but more importantly the housing market continues to heal and support household formations. However, it is unlikely that inflation will accelerate meaningfully until slack in the labor market is taken out and/or we start to see rising unit labor costs.

From an asset class perspective, the Fed's dovish sentiment should help stabilize the U.S. dollar. Immediately following the release the dollar weakened modestly, but with European and Japanese central banks pursuing negative interest rate policies (NIRP), the dollar will likely continue to attract buyers. Any weakening of the U.S. dollar will support emerging markets that have issued U.S. denominated debt and will take pressure off of China's need to manage their currency. This would bode well for investors able to allocate to select emerging market currencies and local bond markets.

Overall, a more dovish Fed should support risky assets, in particular high yield credit that benefits both from falling yields as well as economic growth. Moreover, despite a strong rally, gold and precious metals could continue to gain amid the current NIRP environment. Prior to negative interest rates gold suffered from storage costs and its lack of yield, however, in the current environment cash yields next to nothing and with negative rates incurs storage costs.

Commentary by Matthew Whitbread, investment manager, Baring Asset Management. Matthew joined Barings in 2011 from FundQuest Incorporated where he was a portfolio manager. Prior to this he worked at Pyramis Global Advisors as a senior portfolio analyst for over two years. He also spent six years at MFS Investment Management where he started as a corporate actions specialist before becoming an equity research associate.

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