Wednesday the Fed released its Minutes which is the Fed’s updated view of various markets, the economy, and its thoughts on the possibility of rate hikes or cuts. Lately the Fed hasn’t been in focus nearly as much as it once was. Ever since Alan Greenspan, who was described as the ‘maestro’, the Fed has been studied closely by market participants. The importance of the Fed became particularly heightened after the QE program was initiated by Ben Bernanke’s Fed. The market would increase its level of volatility in the past two years whenever rate hikes were discussed. After the rate hike in December 2015, the market had a sharp correction. Credit spreads indicated the possibility of a recession in early 2016 due to weakness in the economy and the fact that the Fed was tightening.
Some say the Fed took extraordinary action because the financial crisis threatened the stability of the economy. The narrative continues that because Congress and the President couldn’t agree on fiscal policy, the Fed stepped in to help prop up the economy. It’s not the job of fiscal or monetary policy to boost the economy, but pressure from the public has mounted because long term GDP moving averages have been falling to the lowest levels in decades.
Ever since President Trump was elected, the relationship between markets and the Fed has distanced. It’s weird to see the market ignore statements by the Fed as if they don’t matter. The Fed guided for 3 rate hikes in 2017, late last year. The market has consistently priced in 2 rate hikes. It is expecting one hike in June and one hike in December. This consistency may be partially responsible for why Fed statements haven’t led to increased volatility.
In 2009-2011 the most important report was the non-farm payrolls. Afterwards it became Fed statements. Now the handoff has taken place as the market is expecting fiscal policy to take control because the GOP controls all the branches of government. This is great for the market because the Fed’s ZIRP was inherently unsustainable. The punchbowl was always threatened to be taken away. With fiscal policy, Trump never says anything which will hurt the markets. He always speaks about how amazing policy will be for business which is music to the stock market’s ears.
This explanation I gave was meant to give a background on why the stock market didn’t respond to the Fed’s statement Wednesday. I don’t think it mattered to the market what was said if there wasn’t an extreme policy change. The Fed Minutes was the exact opposite of an extreme change as there wasn’t anything new. The chance of a rate hike in May increased by 5.2%. There’s still only a 51.1% chance of a rate hike in May, so the FOMC statement in March would need to express an increase in hawkish tone to move the market. The reason why I pointed out the change in May’s statement is because it was the month which had the most volume as shown on the CME Group website.
While stocks ignored the Fed Minutes there were small movements in other asset classes. The dollar fell slightly. The dollar has been rallying strongly in the past few weeks, but remains below the December high. I considered the dollar’s decline in January to be a change in the direction of the Trump trade. Trump’s ‘America First’ plans were thought to be dollar positive even though he spoke against the dollar to try to help American exports.
The stalling out of the dollar rally without a crash or spike higher has been great for equities. If the dollar passes its December high, it will begin to heart multinational corporate earnings. If the dollar maintains this range between the highs $90s and the lows $100s, it is the perfect scenario for stocks to keep rallying. The 10-year bond yield fell 4 basis points in reaction to the Minutes. It has almost an identical chart to the dollar. Inflation has been increasing as mentioned in the Minutes, but it’s still low enough to not be a concern. Fixed income yields are still low enough that stocks are still the only game in town for investors.
I have focused in my past articles on the difference between the Fed’s guidance for 3 rates hikes in 2017 and the market’s expectation for 2 hikes. I now think this is the wrong way to look at monetary policy. The correct thing to focus on is when the fiscal policy improvements will cause the Fed to raise rates at an accelerated pace. In this statement the Fed moved towards front running the policies and raising rates before they start helping the economy. The timeline for passing tax reform is late 2017; healthcare reform will come in early 2018. The economic effects will come in 2018. If the Fed decides to front runs these policies, it will start raising rates at a quicker pace in the second half of this year. If it waits for them to shows signs that they are working, it will move in the middle of next year.
There was no updated statement on the Fed’s balance sheet which adds to what it has previously said. This means the Fed will act after the ECB decides what it will do to its balance sheet in the summer. I don’t see any chance the ECB will sell the assets it just bought anytime soon. The decision will be whether to continue the $60 billion per month bond buying program which ends in December. If the Fed wants to shrink the balance sheet, it may be better to wait until after the ECB ends its bond buying program to limit the effects on the dollar.
The final point I have is President Trump has recently made statements that he’s concerned about the deficit. There was a narrative that Trump was going to blow up the deficit with tax cuts and infrastructure spending which would cause the Fed to backstop the government with QE. This narrative no longer is fair given the updated fiscal policy discussions.
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