The Markets’ Reactions To Fed Decision
The Fed raised rates by 25 basis points and increased the guidance for rate hikes in 2019 and 2020. I consider this to be a hawkish decision. We’ll go over the wording of the statement in this article, but first let’s look at the markets’ reactions to this decision and guidance. Stocks initially reacted positively to the news as the S&P 500 went from 2,734 to 2,738. I was flummoxed by the fact that stocks were up so much on the day since the Fed pushed guidance in a hawkish direction.
Personally, I don’t value the Fed’s economic forecasts. I do my own analysis and compare it with the Fed’s projections to see if the Fed is too optimistic or pessimistic. The reason why I’m mentioning this is because the market shouldn’t be excited that the Fed is optimistic about the economy. It’s not news because the Fed just reviews the data we already know. I think the Fed is slightly too optimistic, but either way the rate hike guidance is a bigger deal than the GDP forecast, meaning stocks should’ve fallen. Stocks ended up declining as the S&P 500 closed down 0.18% to 2,712. We’ll need to wait longer to seen when the market breaks out of this range.
The dollar index was down from $90.37 to $89.65. That’s an unusual outcome because the dollar has been increasing when stocks have fallen in the past few months. Technically, this decline isn’t important because the dollar index is still above its closing low of $88.59 which it made on February 15th. The range it has been in the past 2 months is between $88 and $91. Until it’s breaks out of that range, there’s not much to analyze.
Interestingly, the Fed fund futures became slightly more dovish after this decision and guidance. The chance of 2 hikes in 2018 went up 1.8% to 21.1%, the chance of 3 hikes went up 2.4% to 41.9%, and the chance of 4 hikes fell from 29.4% to 27.8%. I’m slightly surprised with such a small reaction since stocks fell somewhat sharply after the announcement.
The 10 year treasury had the exact opposite reaction as the stock market; it sold off for about a half hour after the news and then rallied to the end of the day. It peaked at 2.93% and ended the day at 2.88%. This is another financial asset which has been range bound. The 2 year yield fell sharply as it was down about 4.5 basis points. This means the bond market felt the Fed was dovish. As you can see, there was an inconsistent reaction to the Fed decision among various markets. The yield curve steepened as the difference between the 10 year and 2 year yield is now 57 basis points. It would be great news if the Fed could hike rates 4 times without an inversion this year. The Fed is taking what the market is giving it. The Fed is being allowed to raise rates, so it is doing it. The key is to not push the envelop too far because it can easily invert the curve with a mistake in the next 12 months.
Text Of The Fed’s Statement
The first 2 paragraphs are the only ones with changes to the language. As you can see, economic activity is seen to be rising at a moderate rate instead of a solid rate. That seems to be a slight downgrade in measuring the economy. The Fed seems to be more optimistic about the labor market since it says job gains were strong. That’s the obvious position because the February report was amazing. The Fed then says the growth in household spending and business fixed investment moderated since the strong 4th quarter readings. This is in response to the weak retail sales and the slowdown in business fixed investment after the hurricane boost ended. This is very dovish language. Then the Fed adds the economic outlook has recently strengthened. This is based on the expectation that the tax cuts will boost economic growth. I’m waiting to see this boost, but I haven’t seen acceleration outside of manufacturing. Finally, the Fed said economic activity will expand in the medium term and inflation will move up in the coming months.
The fact that this statement had dovish and hawkish points could be interpreted as dovish because the Fed is in the middle of hiking rates, possibly at the most aggressive pace of this business cycle. It’s somewhat remarkable to see a neutral tone in the midst of this. It seems like the Fed is hedging its bet. Even though it expects 2018 to be a very good year for the economy, it didn’t write a consistently optimistic message. That might simply be because the facts don’t back the Fed up. The economy isn’t doing that well as February was weak in some areas.
Fed About To Be Hawkish
The chart below signals the Fed is about to be too tight. It looks at the natural rate of interest compared to the real policy rate. As you can see, the real Fed funds rate is about to be too high. The real Fed funds curve will be above the natural rate for the next 12 months. When you adjust for QE tightening, the Fed funds rate is way too tight, probably indicating a recession in the next few years. The chart doesn’t label the yield curve, so I’m not sure which maturity dated bonds are used to come up with a difference of 121 basis points. Based on the current prices, it might be the 30 year bond yield minus the 6 month treasury bill.
Conclusion
The Fed statement was a mixed bag. I think the Fed will invert the yield curve sometime in the 2nd half of this year or the 1st half of next year. According, to the chart above, the Fed is about to be too tight. That’s an early warning sign for sign for a recession.
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