Fed's shift supports upside for risk assets

Last week, the Federal Reserve announced a widely anticipated shift to target inflation “that averages 2% over time.” Our view remains that the provision of central bank liquidity, the “Fed story,” is key to understanding the current market environment. The Fed’s confirmation of the shift underpins our view and has wide-ranging implications for asset prices.

After periods of persistent below-target inflation, the Fed says it will aim to “achieve inflation moderately above 2% for some time.” Under this new framework, the Fed is likely to refrain from tightening rates until inflation overshoots the 2% target. The Fed also subtly changed its language on employment, which is likely to mean that low unemployment alone would not lead them to hike rates.

With core inflation currently well shy of the 2% target and the economy operating far below full capacity, rates will likely stay very low for an extended period. Notably, the Fed has not managed to hit its 2% inflation target sustainably in recent years, despite a decade-long expansion after the 2008 financial crisis. We have kept our yield forecasts unchanged and still expect US Treasury yields to move only slowly higher as the economy continues to recover. We forecast 10-year yields to reach 0.85% by June 2021.

In our view, the Fed is likely to provide guidance about keeping the funds rate at zero for as long as is necessary to ensure full employment and an overshoot of inflation.

The Fed provided little new input last week beyond the expected target change, so focus has shifted from the policy framework to how the Fed might implement it. Investors expect further details to be forthcoming at the September FOMC meeting. Questions remain about by how much, and for how long, the Fed will be prepared to tolerate inflation above 2%.

In our view, the Fed is likely to provide guidance about keeping the funds rate at zero for as long as is necessary to ensure full employment and an overshoot of inflation. It may also extend the duration of its asset purchase program. We think the Fed will want to keep rates low across the yield curve, in line with its desire to maintain ultra-loose financial conditions until its policy objectives have been met.

The net result is that the Fed has emphasized its dovish policy shift, one which has several implications for asset prices:

1. Central bank liquidity underpins the equity rally.

• Fed policy has been a key driver of the 57% US equity rally (measured by the S&P 500) since the post-COVID-19 low point in March. Ultra-low interest rates make it rational for investors to pay more for a given dollar of equity earnings, justifying higher valuations. In the next leg of the rally we prefer stocks that have lagged behind so far, including select cyclical and value stocks. Read more here.

2. Investors will need to search harder for yield.

• With the Fed keeping rates lower for longer, cash and the safest bonds are likely to deliver negative real returns for the foreseeable future. To protect purchasing power, investors should keep cash holdings to a minimum and will need to search harder for yield. But we see a number of ways investors can find income for their portfolios. We prefer select credit segments including US dollar denominated emerging market sovereign bonds and Asia high yield credit. We also like Asian high-yielding currencies. Click here for more on the hunt for yield.

3. The Fed's new framework opens the door to further US dollar depreciation.

• The Fed has never lowered rates below the zero bound and between 2015 and 2019 even hiked rates as the economy improved. This gave the USD a rather exclusive role as a safe haven and a relatively high yielding currency. But the Fed will now likely wait even longer into the recovery before it starts its hiking cycle again. We continue to look for a 1.15 to 1.20 trading range for EURUSD. A clear break higher is, in our view, only possible once the European and global growth recovery is on firmer footing. However, last week’s decision suggests that a test of 1.20 has moved closer. Click here for more on adjusting to a weaker US dollar.

4. Gold will continue to be supported by negative real rates and a weaker dollar.

• The precious metal is already one of the top performing assets of 2020, up around 29%. Since gold does not provide a yield, a negative real interest rate eliminates the opportunity cost of holding the metal relative to cash or fixed income. We think gold will continue to be supported by ultra-easy monetary policy, a weak US dollar, and policy uncertainty ahead of the US election. Click here for more on gold and commodities.

We see the move in Fed policy as confirming an important shift that could also put pressure on other central banks—such as the European Central Bank—to tolerate higher levels of inflation. That should provide additional support for risk assets.

Visit our website for more UBS CIO investment views.

Please visit ubs.com/cio-disclaimer #shareUBS