Not Dovish Enough? Thornburg’s Brady on the Fed and Markets


December 20, 2018 [raising rates, the federal reserve, volatility, Jason Brady]

The U.S. Federal Reserve has roiled markets with its latest rate hike and comments from Chairman Jerome Powell, who disappointed many investors as insufficiently dovish in his December 19 remarks.


The S&P 500 Index has plummeted to a 15-month low and is on track to post its worst yearly return since the 2008 Financial Crisis. The 10-year U.S. Treasury yield has dropped nearly 50 basis points in little more than a month and the dollar has stumbled. Was the Fed wrong, or are markets over-reacting?

Thornburg President and CEO Jason Brady makes the following points:

  • The Fed cut its key rate to near zero and engaged in “Quantitative Easing” in a years-long response to the Financial crisis. Its “reaction function” and messaging conveyed that equity levels and market sentiment were important inputs in its economic models. Since the S&P 500 bottomed in March of 2009, its total annualized return amounts to 18%. Moreover, this year’s 6.1% decline in the blue-chip index follows a 20% advance in 2017. The Fed seems more worried about financial instability from overheated asset prices than asset prices falling too low.
  • The Fed’s dual mandate comes from Congress, not the President, and obligates it to pursue sustainably low unemployment and inflation around 2%. The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is generally considered to run close to or at 5%. Unemployment is currently 3.7%. While the Fed’s preferred PCE inflation gauge recently came in at 1.8%, headline CPI, which includes food and energy prices, printed at 2.2%. Meanwhile, rising wages are pressuring unit labor costs, threatening corporate profit margins.
  • The Taylor rule, a mechanical model incorporating these inputs, suggests the Federal funds rate should now be 4.5%, two points higher than Wednesday’s 25-basis point hike to 2.5%. Even if the “Neutral Real Rate,” or R*, is assumed at 1%, rather than the common 2%, the Taylor Rule output of 3.5% remains a point above the current level. The Fed appears to be behind the curve.
  • While “Quantitative Tightening” to reverse the expansion of its balance sheet is happening concurrently, investors should keep in mind U.S. economic conditions remain quite strong. Private investment, including non-residential fixed investment, has been rising this year, along with commercial and industrial bank loans. Projected U.S. and global economic growth rates in 2019 of close to 2.5% and 3.5%, respectively, are good, not dire.

The Fed shouldn’t have been more dovish, Brady believes. It cut projected rate hikes in 2019 to two from three and softened its language around guidance. Though it’s “data-dependent,” it must also be forward looking, and not easily swayed by market sentiment, as if the market never overshoots or undershoots and risk asset prices never diverge from economic or corporate fundamentals. The Fed also has ample room to pause its hiking cycle in March or later. Investors shouldn’t expect the Fed to ignore economic fundamentals and stand pat on, or cut, rates simply because asset prices fall rather than rise.

The volatility may be unsettling. But it can lead to more reasonable, if not attractive, asset prices that better reflect fundamentals and future prospects. Frothy valuations from easy money should be at least as unsettling as the volatility that its removal creates. Indeed, longer-term investors should welcome such periodic turbulence, given the opportunities it creates.

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