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Hey Jay, what was all that auto-pilot balance sheet talk about in December?

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      By Andrew Szczurowski, CFA, Portfolio Manager, Global Income Group, Eaton Vance Management

      Boston - Markets were expecting a very dovish message coming into this week's Federal Open Market Committee (FOMC) meeting, and I thought it would be hard for the Fed to live up to expectations.

      Overall, the market was looking for a downward revision in the Fed's dot plot from two projected hikes in 2019, to one hike. Consensus expectations were also for the Fed to potentially signal an end to the balance sheet unwind by the end of 2019.

      The Fed didn't disappoint. In fact, it exceeded even the most dovish expectations. The majority of the FOMC went from having two hikes penciled in for 2019, to now zero. It will end the balance sheet rundown in September, not December. The Fed will also begin to taper its Treasury runoff in May, allowing only $15 billion of Treasurys to run off per month, cut in half from the current pace of $30 billion.

      These are some pretty big shifts from the Fed in a short period of time. Just three months ago, Fed chief Jerome "Jay" Powell said the balance sheet rundown was on "auto-pilot." This sent markets into a tailspin, as some investors thought this approach was too rigid.

      Now, some are wondering why Powell and the FOMC changed direction so quickly. My view is that the sell-off in the fourth quarter of 2018 unnerved the Fed, and led to a pause. But for nearly the past three months, the U.S. stock market has recovered nearly all the losses. Credit spreads have narrowed and inflation expectations are back to the same levels they were at in October. So why has the Fed changed its stance so dramatically?

      It does seem like gross domestic product (GDP) growth will be weak again in the first quarter of 2019. But we have seen this pattern many times. Over the past 18 years, GDP growth has averaged just 1.4% in the first quarter, compared with nearly 2.8% in the second quarter, according to data from the U.S. Bureau of Economic Analysis.

      We also had the government shutdown for most of January, which will also weigh on first-quarter growth. Basically, I think the Fed realized that in the global central bank policy-normalization race, the Fed is the only one running. Everyone else is still stretching back at the starting line. I believe the Fed has decided it can walk for a bit and catch its breath, and perhaps let some other central banks catch up.

      Is there a risk in this approach? The risk is the same one the Fed was concerned about in the middle of 2018 -- creating financial imbalances. But for now, it seems the Fed is conceding to markets, and putting that risk on the back burner.

      So where does the Fed go from here? The answer could be: nowhere. At the post-announcement press conference Wednesday, Powell said the data is not currently sending a signal that the Fed needs to move in one direction or the other. "The reason we are on hold is because we think our policy rate is in a good place, and we think the economy is in a good place," Powell said.

      Bottom line: I believe the real question investors need to ask themselves is where will the U.S. economic data go from here. My view is that after a weak first quarter, the data will start to rebound in the second quarter. The market certainly isn't pricing that outcome as likely. Just look at the inversion at the front end of the Treasury yield curve. As of Wednesday, the 5-year Treasury note was yielding 2.34%, according to, below the effective fund funds rate of 2.4%. So the consensus view has clearly become more comfortable taking interest-rate risk, despite there being no term premium in the Treasury curve. The problem with consensus trades is that when everyone is on the same side, it often produces below-consensus returns.