Fed gears up for accommodation amid inexplicable inflation & unchartered trade war

Highlights:
- Fed keeps policy rate steady but signals a more dovish stance
- Strong US domestic macro, though weaker business income needs a close watch
- Subdued inflation and weaker global growth raises uncertainties for a positive outlook
- Accommodative Fed and a moderate growth outlook positive for EMs such as India
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In its June meeting, Federal Reserve Chairman Jerome Powell and his team has brought in a signalling effect, which market participants anticipated – a signal for one or more rate cuts later this year. As per Federal Reserve Dot Plot, eight out of 17 Federal Open Market Committee (FOMC) members expect a rate cut later this year compared to no such expectations at its March meeting.

This along with Mario Draghi statement a day before where he mentioned readiness for stimulus measures in the absence of macro-economic improvement makes a case for monetary accommodation – a clear shift from the monetary policy pause seen in the last six months.

Read: US recession risk: Position for defensives

Reacting to the policy announcement, US Treasury bond yields have further declined. The US 10-year yield is now below 2 percent, which was last seen before US President Donald Trump got elected. The US treasury yield curve has steepened, wherein the short-term yield has fallen more than the longer end. Steepening of the yield curve could be seen as faith reposed in the Fed that it will do what it can to keep the economic expansion going. Policy uncertainty has abated and so has the CBOE VIX, which clamped down to recent lows.

Macro readings
Unlike other select major countries that are grappling with a macro-economic slowdown, the Fed’s observation remains positive for the domestic labour market and economic fundamentals. However, there are few nuances which the Fed highlighted:

1. While the recent job data for May was lower-than-expected, many other labour market indicators remain strong. Wages are rising, particularly so for lower-paying jobs.
2. Consumption growth, which was weak in the early part of the year, has bounced back as per recent household spending data.

Having said that, the decline in business income in Q2 and a weaker business investment raises concerns.

What made the Fed dovish?The Fed’s apparent change in stance is mainly guided by inflation readings and global growth concerns. Recent global growth indicators have been disappointing, partially weighed by the ongoing trade spat.

FOMC members expressed concerns about the pace of inflation’s return to its two percent target. Near term inflation projections for 2019 has been brought down to 1.5 percent versus 1.8 percent at its March meeting. However, FOMC remains sanguine about reaching closer to its inflation target by next year.

Risks: Key structural risk to watch out for is persistence of lower inflation even if the economy is strong. For such a scenario, policy responses are not straight forward and may require lot of deliberation. Here, it is interesting to note the FOMC’s longer-term projection for policy rate has also come down to 2.5 percent (versus 2.8 percent earlier), suggesting policy rates have clearly peaked in the current interest rate cycle.

Major risk to watch in the near term is spiralling impact of a US-China trade war. In the last couple of days, the Trump administration has indicated rapprochement and trade talks. The key event to watch out for would be Xi-Trump meet on the sidelines of the G-20 meet (June 28-29).

Takeaways: In light of recent global central bank’s monetary accommodation and fragile global growth, our view remains that unlike earlier phases of quantitative easing (QE) a rising tide may not lift all boats. And hence, investors need to be selective about stocks and sectors. Having said that, a scenario of weaker dollar and moderate global growth is positive for fund flows to emerging markets such as India.

Sectors where investors can increase allocation are defensives such as consumer staples that tend to outperform during weak global macroeconomic phases. Sectors or companies from global cyclicals (pharma APIs and chemicals), which have the resources to take advantage of the US-China trade dynamics, could be interesting. Here, a policy push for job creation and Make in India campaign can be expected.

Also read: Tariff Play | Trade war cloud darkens, but India sees a silver lining

Sectors that are witnessing green shoots or are expected to get disproportionate policy attention need to be watched like capital goods.

Follow @anubhavsays

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