On Monday morning, in previewing Wednesday’s FOMC decision, UBS fixed income specialist Dan Noorian while explaining that any substantial deviation from the Fed’s dot plot could have dramatic consequences for the fixed income market, said that at least one aspect of the upcoming announcement is ironclad: “no one seriously expects the Fed to leave rates unchanged on Wednesday.”
And yet, less than 24 hours later and another 500 Dow points lower, that is suddenly looking precariously iffy for two main reasons.
The first one, as we first explained back in September 2015 just before the first expected rate hike, is that the Fed really hates surprising the market, especially just ahead of FOMC day. As Morgan Stanley explained back in 2015, “surprises matter to the Fed, because surprises can lead to a bigger tightening in financial conditions than is warranted.” i.e., markets will dump.
And the punchline: during prior tightening cycles, such as 1999 and 2004, the Fed would only raise rates if the market implied odds for a hike 1 day prior to the announcement decision were 70% or higher.
This is important because whereas rate hike odds heading into this week’s decision were solidly above 70% for mcuh of the past three months, they dipped just below today, sliding to 68 and lower following today’s market rout.
The second reason why a rate hike on Wednesday is suddenly looking quite questionable is that as Bloomberg points out, a rate hike now would be the only first time in 24 years, or since 1994, that the Fed tightened in a market “this brutal.” To wit, the S&P 500 is down over the last three, six and 12 months, a backdrop that has accompanied just two of 76 rate increases since 1980. And yet even as half the S&P 500 sits in a bear market and groups like banks and transports tumble day after day, strong economic data continues bolster the case of hawks; this presents yet another snapshot of the divide between markets and the economy, a split that has confused forecasters trying to draw connections between the two.
This, according to David Rosenberg, presents an interesting dilemma for the Fed: “Financial markets are telling them ‘no mas,’ but the economic data suggest that further tightening remains appropriate.”
Which then brings up the age-old question (one to which everyone knows the answer yet will never get an honest response from the Fed): does the Fed ease conditions to stimulate markets or the economy.
While the answer is and has always been to push risk assets higher – a far easier task – with the assumption the an economic recovery will follow, the Fed itself will never admit this. And yet, even though the role of markets in the Fed’s policy calculus is debated – at least by clueless economic hacks over polite dinner conversations paid for by someone else – the fact is, since 1980, rate hikes have almost always come amid rising stock markets. On average, the S&P 500 is up 4.1 percent, 6.9 percent to 11 percent over the previous three, six and 12 months when tightening occurs. The exception was in the 1970s, when the Fed ignored market turmoil to combat inflation that was running at 7% a year.
Even stranger, while the economy right now is growing solidly at or about 3% (if slowing) with near full unemployment and rising inflation, and a Fed report earlier this month said it viewed financial-stability concerns as moderate – citing commercial real estate, corporate debt and leveraged loans among the potential issues – traders are clearly nervous amid a market rout that’s erased $3 trillion from American equity values, with many – the US president included – now calling for a pause.
To this, the traditional response has been: just how strong is this “recovery” if the economy can’t withstand rates of 2.5%, and furthermore, just how fake has the equity “bull market” of the past decade been if it instantly disintegrates the moment the Fed suggests it may be serious with normalizing monetary policy.
In any case, many strategists are now convinced that eight rate increases in three years have been enough for an economy threatened by everything from U.S.-China trade spat to Brexit and a global growth slowdown.
So what are Powell’s options?
He can pretend as if nothing has happened, hike, and keep the “dots” unchanged, implying another 3 hikes in 2019, sending markets crashing; he can not hike and indicate that a pause – or halt – in the hiking cycle is imminent, or he can do something inbetween.
“The Fed needs to deliver on a more dovish stance to avoid disappointing financial markets,” said Mark Haefele, chief investment officer for UBS Global Wealth Management. “A rate increase looks likely. But signs of flexibility from the Fed have caused markets to scale back the expected pace of tightening in 2019.”
To be sure, should Powell hike – and many say he will do so just to prove he is independent of Trump who has been pushing the Fed to end its ratehikes – it wouldn’t be the first time the market pukes as a result. In December 2015, Janet Yellen pushed ahead with the first rate increase of the cycle just two months after the S&P 500’s worst drop in four years. After stocks tumbled into a 10% correction, the Fed chair delayed more hikes for a year.
The latest equity sell-off has been bad enough for Fed officials to take notice. Mentions of “financial stability” have increased in Fed commentary to the year’s high of 5.7 percent while comments on inflation and employment dropped, according to data compiled by Bianco Research on speeches, statements, minutes or testimonies.
Finally, the all important question: has the recent market rout been sufficient to change Powell’s mind?
According to Bank of America, the answer – so far – is now, as “the bloodletting in stocks probably hasn’t gotten to a pitch where the Fed would abandon tightening, according to Bank of America.” And indeed, when Powell proceeded with another increase right after the equity rout in February showed he’s less worried about financial markets than Yellen was in 2015, strategists led by Benjamin Bowler said.
“Partly this could be a difference in approach of the individuals and economic conditions,” BofA strategists wrote in the note. However, “With 200 basis points of rate hikes under the Fed’s belt today, they are in a better position and are more able to manage policy to the real economy (their job) rather than the market.”
Of course, just why the Fed needs compelled to keep hiking, and thus break the market in the process…
… just so it can ease from a higher spot, is anyone’s guess, especially since most traders already expect that the next recession in addition to QE4 will likely also culminate in negative interest rates.
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