Fed Raises Rates: Stocks & Bonds Rally

The Fed announced it raised rates 25 basis points in its March statement. Furthermore, it stated it would be raising rates two more times in 2017 and three times in 2018. Finally, Yellen stated there wouldn’t be any near-term movement to unwind the Fed’s $4.5 trillion balance sheet. There is a lot to unpack with the latest announcement. I will analyze the economic context the policy change was made in and the latest moves various markets are making in response to the statement.

In comparison to my projections, I’d say this statement combined with the ensuing points made by Yellen were more dovish than I expected even though the Fed was hawkish on rates. The reason it is more dovish than I expected is because I anticipated the rate hike and the guidance for future rate hikes. However, I did not anticipate the guidance for no change in the Fed’s balance sheet. The Goldman Sachs forecast for the Fed to start unwinding the balance sheet in Q4 2017 is clearly wrong. With the latest statements by Yellen, it may not even happen in mid-2018.

Before I start to delve into the details of the statement, let’s give context for the Fed’s announcement today. Today, the Atlanta Fed lowered its Q1 GDP forecast from 1.2% growth to 0.9% growth. This shows the Fed’s action and guidance is out of sync with the economic reality. If growth was in the 2% range before the fiscal policy stimulus kicked in, it would make more sense to raise rates because there’s less risk in case the fiscal policy doesn’t work or isn’t passed. However, with a weakening economy, the Fed needs fiscal policy to work. The Fed has acted in an unprecedented manner this cycle. It had been responding to the stock market which tends to be fickle and now its responding to political rhetoric which is even more uncertain. The Fed has always called for help on the fiscal policy side, but there’s not conclusive evidence it will get it.

As you can see from the chart below, the Atlanta Fed GDP Now forecast has been heading lower since early February. Just when the Fed started to ramp up expectations for a rate hike in March, the GDP Now forecast took a nosedive. The 0.3% decline in GDP expectations was caused by the latest BLS jobs report and retail sales report. The jobs report was good; I’m not sure how the model specifically uses data to come up with its forecast. The retail sales report caused the estimate for Q1 consumer spending growth to fall from 1.6% to 1.5%.

As you can see from the chart below, if the Q1 GDP forecasts are correct, this will be the weakest economy the Fed has raised rates in since 1980. In defense of the Fed, the economy may not be able to grow much faster in its current state. The GDP growth rate per capita has been in a long-term secular downturn. You can argue the Fed is partially to blame for that because it created the previous asset bubbles, but the point I’m making is the Fed was going to have to raise rates in a low GDP growth environment regardless since the recovery has been so weak. In Q4 2015, the Fed raised rates even though the Atlanta Fed expected 1.2% growth and the actual result was 0.9%. That’s an example the Fed doesn’t want to repeat as the market crashed soon afterwards, but, as I said, it may have been necessary because the economy has been weak for a while.

The Taylor Rule now has interest rates being about 275 basis points too low instead of 300 basis points, as seen from the chart below which is from before the latest move. Some of the points I have made have been critical of the Fed’s decision to raise rates. The most obvious criticism is the inconsistency of the decision because the economy had been stronger at other points in the cycle, yet it didn’t raise rates then. The second one is that it is raising rates in a weak economy. It shows the Fed is more respondent to the stock market than the economy as the stock market has appreciated quickly since the election. It’s not that the Fed is trying to prick the stock market bubble as many in the media are saying; the Fed is instead being allowed to raise rates by the stock market. All those criticisms being stated, I think raising rates was the correct decision because the correct response to solving asset bubbles isn’t to keep pumping more air. The accelerated rate hikes have been a long time coming. The recovery would have been even weaker without the Fed. The economy needs to take the pain before real growth can occur.

The stock market rallied moderately in response to the Fed’s action as it has erased most of the 2% correction it had in the past few days. The 10-year bond yield fell over 10 basis points to 2.5% and the 2-year yield fell about 8 basis points to 1.3% which is the biggest move among the various asset classes I’ve looked at. The dollar sold off moderately as the index fell about 1%. These market responses occurred because Yellen’s statement was more dovish than expected as the Fed won’t be cutting its balance sheet anytime soon.

If the Fed sold its bonds, it would cause the dollar to rally as it would signal the economy is strong. It would cause treasuries to selloff because of the increased supply. Higher yields would cause stocks to selloff as bonds would compete more with stocks for investor’s capital. The bullish thesis that bond investors are going to flee to stocks wouldn’t work if the Fed was providing the reason for the selloff. None of these market moves are about to happen now that the Fed said it won’t sell its bonds soon. I will criticize the Fed’s lack of movement on its balance sheet in my next article.

Conclusion

I was tough on the Fed in this article because it raised rates in a weak economy. It is a necessary decision, but it appears the catalyst was a rising stock market and the expected fiscal policy which may not come through. The stock market responded by going into ‘risk on’ mode because the Fed said it wouldn’t unwind the balance sheet anytime soon. I will get into more detail on the balance sheet decision in my next post.