Of Dot Plots and Definitions

On Wednesday, the question of the day was a bit of a head scratcher. You see, after listening intently to first the FOMC statement and then the ensuing press conference, the question on investors' minds was, when a change is made to the Fed's statement on monetary policy and yet the statement itself stresses that the change doesn't represent a real change, did anything a change or not?

By now, most of you are probably well aware of the fact that in her first meeting as Chair of the Federal Open Market Committee (aka "the Fed"), Janet Yellen made some adjustments to the "guidance" relating to what to expect from the Fed in the future.

Based on the reaction of the algos at Virtu, Getco, Citadel, Goldman GS, JPMorgan JPM, et al, traders did not like what they heard. Immediately following the release of the Fed statement, the S&P 500 SPY dove 10 points. However, this is a pretty typical response to Fed announcements. No, the bigger problem came later during the Q&A session of Ms. Yellen's press conference.

What Changed?

For starters, Ms. Yellen dropped the 6.5 percent unemployment rate "threshold" that, up to this point, had been viewed as the trigger that would cause the Fed to begin making changes to monetary policy. And while selling stocks on this may have been programmed into the algos, the move was widely expected.

Ms. Yellen explained that instead of a preset line in the sand (aka 'quantitative-based guidance') that Ben Bernanke wanted the markets to be able to see at all times, the Fed was moving to something a bit less transparent, something that was well, a lot more Fed-like.

In short, Yellen said the FOMC would now be watching what is being referred to as the 'Yellen dashboard.' As has been the case with the vast majority of Ms. Yellen's predecessors, Ms. Yellen declined to detail exactly what she and her fellow Fed Governors will be focusing on. However the new Fed head did mention that the indicators will include data on employment, inflation, and overall financial conditions.

This too may have caused some selling. But, again, it was also expected.

In addition, the FOMC members cut their forecasts for the rate of unemployment (a good thing) for 2014, 2015, and 2016. There was also some improvement in the forecasts on the outlook for the economy.

However, Yellen made it very clear at the press conference that the new guidance provided by the Fed does not reflect a change in overall policy intentions.

The "Dot Plot"

Although Fed Chair Yellen also cautioned against reading too much into the so-called "dot plot," (the prediction of the Fed Funds rate from each Fed Governor is plotted on a chart - see below) the bottom line is that the median target for the Federal Funds rate at year-end rose for both 2015 and 2016.

Year-End Federal Funds Target - AKA The "Dot Plot"

For those not well versed in fed-speak, this means that the median year-end target for the Fed Funds rate in 2015 is now 1.00 percent. The problem is this is up from the 0.75 percent level from the last plotting of the dots. And then the median prediction for the Funds rate at the end of 2016 rose to 2.25 percent from 1.75 percent.

There are two points to be made. First, let's keep in mind that the current target for the Fed Funds rate is 0 - 0.25 percent.

Second, and more importantly, the current dot plot suggests that the FOMC will begin hiking rates sooner and/or more aggressively than previously thought. NOW we're talking. NOW the algos had something to sink their teeth into.

While this sounds like a logical explanation for the Dow's DIA triple-digit decline, the bottom line is that the big dive didn't happen until Ms. Yellen started answering reporter questions.

Getting Some Clarity

How do we know that it was something Ms. Yellen said and not the combination of the changes (that weren't supposed to be changes)? By watching the 1-minute chart of the stock market, of course.

As the new Fed Chair's press conference wore on (and on), suddenly, out of nowhere, the DJIA dove 170 points in less than 10 minutes. This, dear readers, is how you KNOW something is up.

It turns out that Janet Yellen had, whether intentionally or not, provided some clarity on what a "considerable" amount of time was. And based on the reaction in the market, this was a surprise - and not the good kind.

Recall that in the Fed's statement, the committee had said that the benchmark federal-funds rate would remain near zero for a “considerable time” after the QE bond-buying program ended. Then, for the first time, Ms. Yellen attempted to define that term, saying it was “hard to define” but “probably means something on the order of around six months.”

Wham! Down she went. Here's the problem... The consensus expectation for when the Fed will start raising interest rates is sometime in the third quarter of 2015. However, with the QE program set to taper to zero by year end, this means that Ms. Yellen and Co. could start raising rates in June. And the bottom line is this is EARLIER than expected.

THIS was something new. THIS is why the S&P was pounded for 1 percent in under 10 minutes. And THIS is why traders were suddenly freaking out.

Granted, stocks recovered about half of the algo-induced dive into the close. However it is worth noting that the markets don't like surprises, and THIS is the type of surprise that could be with us for a while. Stay tuned, this is about to get interesting.

Positions in stocks mentioned: SPY

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