At a press conference in the run up to Gulf War II, then-Defense Secretary Don Rumsfeld outlined his mental construct for assessing risk. The topic at hand was whether Iraq had weapons of mass destruction, but the framework applies to all decision-making. To Rumsfeld, all the inputs for evaluating an issue fall into 3 buckets:
- “Known knowns”: things we can be certain about.
- “Known unknowns”: things we recognize we don’t know with certainty.
- “Unknown unknowns”: things about which we have no idea and don’t even have the insight to ask about.
- All this worked well enough for the US to win the war that was to come; the “peace” that followed was, of course, a case study in how “unknown unknowns” can rule the day.
We bring this up because the coming week in US/global stocks has its share of all three sorts of factors:
- One “known known”: the certainty of an upcoming Federal Reserve meeting and Wednesday Chair press conference.
- The “known unknowns” of US/China trade talks and Brexit.
- The “unknown unknowns” of DC political uncertainty, as exemplified by last week’s events.
If history is any guide, the Fed meeting should swamp the other two issues in the week ahead. That’s because of something called the “Fed drift”, a stock market anomaly first outlined by the NY Fed in a 2012 paper and recently updated by them to include data up to 2017. Here is how it works:
- US stocks (and many other developed economy equity markets as well) tend to rally from the day before a Fed meeting to the end of the day afterwards. That’s the “drift”, and it does not primarily occur after a rate decision. Rather, most of it occurs in the 1½ days before any meeting-related headlines cross the tape.
- Cumulative return data from 1994 to 2011 showed that virtually ALL the S&P’s annual positive price performance over that period happened in these 3-day windows.
- The NY Fed’s 2018 update, published in late November (and reviewed by us the week after in a subscriber note) showed that the “Fed drift” stock market anomaly now only applies to Fed meetings with an accompanying Chair press conference and releases of a new Summary of Economic Projections (SEP).
Fed researchers had the same question you are no doubt asking: “Why does the “Fed drift” continue to work even though everyone knows of its existence?” They had no clear answers. Chair Powell’s decision to have a press conference after every meeting next year should help them (and traders) isolate the issue further. And, perhaps, stop the “drift” with more regular central bank communication.
As far as what Chair Powell might say on Wednesday to engage the “Fed drift” and rally US stocks, he need only look at what Fed Funds Futures already price in for future rate policy:
- Futures give 77% odds the Fed will raise rates on Wednesday by 25 basis points to a range of 2.25% – 2.50%.
Not going down that path will almost certainly spook US equities. With so many “known/unknown unknowns” already in the mix, investors would assume the Fed had knowledge of some impending crisis about which they are unaware.
- Futures markets now assume the Fed will most likely be on hold through the first half of 2019. They place only 36% odds of a 25 bp rate increase (to 2.50% – 2.75%) through June, for example. The chances of any more than that are just 10%.
- By the end of 2019, futures give the same odds (37% each) to “no increase” and “one increase” for the entire year.
- The most bullish signal for equities: futures give slim odds (less than 10%) that the Fed will have to cut rates back to current levels in 2019 if they move on Wednesday. Translation: the US economy can withstand slightly higher interest rates, trade concerns, and political risk without needing the Federal Reserve to bail them out.
Getting Chair Powell to accept this stance may be easier than herding the cats at the Federal Open Market Committee meeting to go along and incorporate the market’s rate outlook as their own. As of September’s SEP, the group was still calling for 3 rate increases next year, not the “maybe one” that futures currently discount.
If the FOMC does want to follow the market’s lead, they will have to:
- Cut their GDP forecasts, currently at 2.5% for 2019 and 2.0% for 2020…
- … and/or increase their estimate of US unemployment, currently at 3.5% for 2019 and 2020…
- … and/or lower their inflation forecast, which at the moment sits at 2.1% for 2019 and 2020.
The bottom line: in order to soften their rate stance, the Federal Reserve will have to admit the US economy is set to underperform their prior expectations but simultaneously not cast too much doubt on future growth.Changing course on rates without that air cover will make it look like the Fed is targeting asset price volatility (a.k.a. the “Fed Put”) or – worse – that the central bank is taking orders from the White House.
Our thought regarding this week’s US stock price action: we respect the “Fed drift” history enough to believe it should work this week. Markets are hungry for certainty about anything, and Chair Powell can deliver some reassurance that the Fed will remain truly data-dependent rather than auto-piloting policy to some preconceived end. That said, the drift only lasts until Thursday; we have 6 more trading days in 2018 after that.
via RSS https://ift.tt/2SWK0ij Tyler Durden