Fed Reaction: Markets Knew What Was Coming And Behaved Accordingly

Market expectations were spot-on again regarding the direction the Federal Reserve would take on interest rates. As widely predicted, the Fed stepped up the target Fed funds range another 25-basis points to 1% to 1.25% to put it fully across the 1% threshold for the first time since 2008.

The CME FedWatch Tool, a predictive measure of interest rate hikes that uses Fed funds futures, left barely a shadow of a doubt that today’s rate hike was imminent with an unusually lofty 95.8% probability ahead of the announcement. And given the Fed’s predilection for foreshadowing to avoid a market meltdown, any other move might have had negative effects.

The big news wasn’t so much the widely-anticipated rate hike, but rather that the Fed does plan to start tapering its balance sheet this year. According to the post-hike statement, “The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated."

So we know it’s likely to happen, but there’s still no details on exactly when or how much. The Fed’s balance sheet currently stands at around $4.5 trillion, and it’s possible that by re-injecting some of those funds back into the market, the Fed could cause borrowing costs to rise even if it doesn’t execute further rate hikes.

Market reaction looked muted in the minutes after the announcement, with most major indices remaining near record highs but still pretty flat for the day.

Another takeaway from the Fed’s statement is that it may be realizing its original inflation target might have been too aggressive. It now says it expects inflation to stay under its 2% target “in the near term” but to stabilize near 2% over the medium term. The wording about inflation staying under 2% in the near term is new, and wasn’t in the May meeting statement. It likely reflects some weak inflation data lately, including today’s Consumer Price Index (CPI) for May.

In her post-meeting press conference, Fed Chair Janet Yellen said economic fundamentals remain solid, and cited the continued fall in unemployment. She said she expects the job market to strengthen somewhat further. On inflation, Yellen noted that core inflation has “edged lower,” driven significantly by what appeared to be “one-off” reductions in certain categories of prices like wireless telephone services and pharmaceuticals. With employment near its maximum sustainable level, the Committee still expects inflation to move up and stabilize at near 2% over the next couple of years, she added, but said the Fed is monitoring inflation closely due to the recent softness.

Yellen said the federal funds rate remains slightly below its “neutral rate,” even though neutral is low by historic standards. Interest rates, she said, don’t have to rise much to reach it, but additional, “gradual” rate hikes are likely to be necessary over the next few years.

Like most other announcements emanating from the central bank on the day it holds its Federal Open Market Committee (FOMC) meetings, today’s statement noted that the Fed is still worried about the tepid growth in the economy. What appears to be the biggest hurdle to the Fed and Chair Janet Yellen is inflation. The central bank has said repeatedly that its “accommodative policy” balances on maximum employment and 2% inflation. Well, we’re at near capacity—and in some industries well over it—in the jobs department with unemployment at a 16-year low of 4.3% in May. Inflation, however, remains subdued. In today's statement, the FOMC acknowledged that "inflation has declined recently  and, like the measure excluding food and energy prices, is running somewhat below 2 percent."

The Consumer Price Index (CPI), released earlier today, was likely another thorn in the inflation side. CPI fell 0.1% in May, the government reported earlier Wednesday, though core CPI, which strips volatile food and energy prices, did rise 0.1%. Core CPI was up just 1.7% year over year in May, down from 1.9% in April. Additionally, the Fed’s preferred inflation measure, the personal-consumption expenditures price index was up only up only 1.7% on a year-over-year basis in April. Also, today’s month-over-month decline in retail sales is hardly heartwarming, though it reflected in part a big drop in gas prices last month.

Yesterday, the New York Fed’s May Survey of Consumer Expectations marked another retreat in household inflation expectations as the one-year ahead horizon for median expectations fell back to 2.6% from 2.8% in April. Median household spending growth expectations flat lined from the series low of 2.6% in April.

The central bank indicated that it would pump interest rates at least three times this year, and we’ve now had two. The bigger question now is whether the Fed believes the economy has enough oomph to punch out more hikes this year. We’re not likely to find out what the central bank really thinks about such things until three weeks from now when the minutes are released for the public’s parsing pleasure. But, the markets aren’t convinced. At this point, Fed funds futures are projecting about a 39% chance of at least one more quarter-point hike, and only a 5% chance of an additional one.

The Fed’s next two-day meet starts July 25 and by then Fed officials will have seen a bevy of economic reports, including the June jobs report and June retail sales, to deconstruct for more guidance. It also appears likely that there may be more clarity on how Congress decides to deal with the budget, the debt ceiling and a host of other hot legislative topics on the agenda.

Figure 1:SPX DRIFTS LOWER AFTER FED. The S&P 500 (SPX), plotted here Wednesday on the TD Ameritrade thinkorswim® platform, drifted lower after the Fed decision as reaction was relatively muted, at least initially.. Data source: Standard & Poor’s. For illustrative purposes only. Past performance does not guarantee future results.

Meanwhile, the Markets Were…

Chopping around unchanged prior to the release, with the S&P 500 (SPX) a couple ticks lower, but the Dow Jones Industrial Average ($DJI) managed to eke out another all-time high. After the announcement, both stock markets drifted lower.

The Volatility Index (VIX), the market’s fear gauge, has been sitting near historically low levels as the SPX dances around all-time highs. Recall that last week, VIX touched an all-time low of 9.37 before jumping above 12 after a Goldman Sachs report put a damper on the tech sector. After the announcement, VIX settled rose from middle of the 10-handle to above 11.

The Plan to Taper the Balance Sheet

As noted above, the Fed did make mention of the stimulus program aimed at keeping borrowing costs low to resurrect the economy. Though nothing was said publicly at its March meeting, we found out in the official minutes of the meeting three weeks later that there was closed-door chatter on what direction the unwind of $4.5 trillion in mostly U.S. treasuries and mortgage-backed securities would take.

Like the quantitative easing unraveling, the Fed appears ready to do it in a slow-but-sure manner determined by setting and gradually raising caps on the dollar amounts of Treasury and agency securities, according to the Fed minutes.

“As the caps increased, reinvestments would decline, and the monthly reductions in the Federal Reserve’s securities holdings would become larger,” according to the minutes from the May meeting.

“The caps would initially be set at low levels and then be raised every three months, over a set period of time, to their fully phased-in levels. The final values of the caps would then be maintained until the size of the balance sheet was normalized.” 

The market speculation for when the actual process begins ranges from as soon as September (assuming the economy "evolves broadly" per today's statement) to January 2018, which is Yellen’s last official meeting as chair. Her term ends in February.

Remember that these actions are another form of tightening monetary policy, and the Fed believes this controlled approach might “help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates,” according to the minutes.

What Now, Dear Fed?

O.K., the Fed raised rates today, but when will the next hike take place? Remember we’ve got a Fed that is adamant about managing market expectations and is making every effort to be hawkish about pushing rates higher, but has a compositional change in the not-so-distant offing.

Three board seats are open for the president to fill and a chair position if he doesn’t rename Yellen in February. Remember that President Trump, who has built his career on loans, told the Wall Street Journal back in April that he was a fan of low interest rates. “I do like a low-interest rate policy,” he said. “I must be honest with you.” 

How They Voted

The markets love to parse the vote too, keeping close tallies on the dissenters. At this meeting all of the Fed voters voted in favor of a hike, with the exception of Minneapolis Fed president Neel Kashkari, who was also the lone dissenter in March when rates were raised. He’s been a steadfast dove about keeping rates low.