Fed Maintains Rates & Stocks Fall

Fed Maintains Rates

Heading into this rate decision, I expected a hawkish hold. At this point in the cycle, any meeting that doesn’t have a hike is expected to have hawkish language. Probably in 2019 or 2020, the Fed will turn off the spigot of rate hikes, but not yet. As expected, we didn’t get a rate hike. The unexpected part, in my opinion, was the slightly dovish statement which tempers the chances of 4 rate hikes this year. The market had drifted in that hawkish direction because of the increased inflation pressures even though economic growth hasn’t been as high as expected. Fewer rate hikes could extend this business cycle into 2020 as the yield curve remains normal.

Specific Changes To The Fed Statement

Let’s review the changes made to the statement to determine if there were new changes to the FOMC’s guidance. The first change states jobs growth has been strong on average. The “on average” part was added. This reflects the recent lumpiness of the figure as there were only 103,000 jobs added in March which missed estimates for 185,000 jobs added. Essentially, the Fed has made the change to be more statistically accurate without changing the implications behind the statement.

The next change made is that the Fed thinks business fixed investment has continued to grow strongly. That’s a hawkish change since anything positive about the economy signals more rate hikes are possible. The S&P 500 firms reporting earnings seem to be suggesting they are plowing the capital they got from the tax cut into capex. That’s a great sign for improved business fixed investment growth for the rest of the year. On the negative side, the private nonresidential fixed investment grew 7.3% in Q1 2018. While that is reasonably strong, the Q4 growth rate was 7.7%. That doesn’t justify an upgrade in the evaluation of business investment growth.

The next change is the point that the core inflation has come close to the Fed’s target instead of staying below the target. This is simply pointing out the changes in the data. The Fed’s goal has basically been met for the time being. Investors need to realize that the core PCE has been above the Fed’s target this expansion, but it hasn’t stayed above or at the target for any sustainable time period in the past 9 years. Specifically, the core PCE growth stayed above 2% for 4 months in 2012. High inflation is actually a terrible thing so I wouldn’t be rooting for higher inflation if I was a bull. I won’t be worried about core PCE unless it hits 2.5% which is unlikely for the next few months.

It changed the part about market based measures of inflation compensation to saying they remained low instead of including the part about them increasing in the recent months. To be clear, the Fed is talking about breakeven inflation. The 10 year breakeven inflation is at 2.16% which is near the highest point since 2014. However, the pace of increases has moderated. Since the start of the year, the 10  year breakeven inflation is up 20 basis points. Since the start of February, it is only up 5 basis points. If you look at the core PCE or core CPI increases, this market based increase looks like small potatoes.

Next, the Fed eliminated the sentence which stated that the economic outlook strengthened. This is the biggest change we’ve reviewed so far. It makes sense because the consumer spending growth was only 1.1% in Q1 2018. There has been general economic slowing even in manufacturing in the past two months. Heading into this statement I wondered if the Fed was going to acknowledge the weakness or only focus on the uptick in inflation. Clearly, the Fed recognized the economy weakened since the 2nd half of 2017. This is a big dovish change.

Next, the Fed changed its statement on inflation saying it will run near the symmetric 2% target. I think this is also a dovish statement because the Fed clearly doesn’t expect the inflation rate to pick up much higher than 2%. To be fair, the Fed has been consistently wrong in expecting the inflation rate to be near its target. This could be like a broken record which finally happens to be correct. Either way, this is dovish news because the Fed won’t hike rates quickly in anticipation of a big wave of inflation.

The final change is the Fed eliminated the point where it said it is monitoring inflation developments closely. The Fed is always monitoring inflation, so it’s tough to glean anything from that omission. Inflation has picked up, so it makes sense to be more focused on inflation than usual.

Effect On The Markets

The S&P 500 was down on the day. It initially rallied after this Fed statement, but quickly reversed itself closing down 0.72%. I don’t understand why the market would selloff on this statement which is moderately dovish. I might be reading into the small move in the S&P 500 too much especially since the Russell 2000 was up 0.29%. The chances of rate hikes moved a couple of points towards fewer hikes in 2018, but nothing worth reacting to. The 10 year bond yield was flat at 2.96%. It hasn’t moved much in the past few days. The 2 year yield fell 1.6 basis points to 2.49%. It fell 2.1 basis points from right before the Fed announcement until the close. This makes sense because the Fed was slightly dovish. If the Fed would have raised rates, the 2 year yield would have soared which would have flattened the yield curve.

Finally, the dollar index weakened initially after the report and then strengthened to slightly higher than before the statement was released. The Fed being slightly dovish is modestly bearish for the dollar index, but there is still upward pressure for the dollar because the Fed is more hawkish than most of the advanced economies’ central banks. The dollar index has risen over 3 points in the past few days, closing at $92.71 on Wednesday.