Apple Can’t Push Up The Market

Apple (AAPL) is the largest company in America, which means it has the largest weighting in the Nasdaq and the S&P 500. It pulled the Nasdaq to a gain of 0.46%, but the S&P 500 still fell 0.1%. The Russell 2000 fell only 0.09% which implies, excluding AAPL, the small caps outperformed the large caps solidly. I’m not surprised by this modest weakness because the market had gotten overbought. The worst sectors were industrials and energy which were down 1.28% and 1.33%. Caterpillar (CAT) led the way on the decline as it fell 3.66%. Tech and real estate did the best as they were up 0.97% and 0.69%.

The Fed’s decision to keep rates stable had almost no impact on the stock market. The next Fed decision which could affect the stock market is when the Fed decides to finish its rate hikes this cycle. The higher the Fed hikes rates, the more likely each hike will weigh on the market.

10 Year Yield Rises Above 3%

I was wrong to suggest the 10 year yield wouldn’t hit 3% again this cycle as the yield increased 5 basis points on Wednesday to 3.01%. This movement didn’t have much to do with the Fed’s decision. It was caused by the positive economic data. There was so much data released on Wednesday, I will need further articles to get through it all. The 2 year yield, which is more likely to be affected by the Fed’s decision on interest rates, increased 1 basis point to 2.68%. This means the curve had another sharp steepening as the difference between the 10 year yield and the 2 year yield is now 33 basis points. I still stand by my expectation for the curve to invert in Q4 2018.

Another reason rates rose is because the Japanese 10 year bond yield is being allowed to increase, as the JCB slightly softened its dovish tone. As you can see from the chart below, the Japanese 10 year bond yield hit 12.4 basis points. If the JCB continues to allow the 10 year Japanese treasury yield to increase, the U.S. 10 year bond yield can surpass its 2018 high and possibly come close to 4%. This essentially means the JCB is bailing out the Fed by preventing the U.S. curve from inverting. Rising rates will hurt U.S. housing buyers, who are already in trouble because of a lack of affordability.

Fed Decides To Maintain Rates

In a widely expected move, the Fed decided to keep rates steady. They are currently in the range between 1.75% and 2%. The statement was short again as Powell wants to use press conferences to explain policy instead of explaining every detail in the FOMC statement. Since it was short, there weren’t many changes. I will review them here.

FOMC Statement Changes

The biggest change, which made all the headlines describing the Fed decision, was where the Fed stated economic activity has been rising at a “strong” rate instead of a “solid rate”, which it wrote in the previous statement. A “strong” rate is an adequate definition of GDP growth of 4.1%. Even though growth above 4% probably won’t be maintained, 2018 looks like it is well on its way to having the fastest GDP growth in this recovery. It’s fair to say this is a hawkish statement, but I don’t look at it as something that implies the Fed will hike rates more quickly. Describing reality doesn’t mean the Fed needs to hike rates more as reality also shows inflation is contained.

The next change is a basic fact as the unemployment rate didn’t fall in June. It “stayed low.” I expect the unemployment rate to fall in July. Either way, the unemployment rate doesn’t tell us about the slack in the labor market which is significant. The next change was minor as the Fed changed the statement which said household spending “picked up and continued to grow strongly.” It now says household spending and business fixed investment “have grown strongly.” Since consumption has been strong for a few months, it’s fair to say it is no longer “picking up.” It is where it needs to be. Business fixed investment has been especially strong ever since the capex boom created by the tax cut and repatriation holiday.

The final change, which has to do with the substance of the Fed’s analysis of the economy, was that the Fed changed its sentence on inflation. It went from saying year over year headline inflation and core inflation have “moved close to 2%” to saying they “remain near 2%.” This is a factual point since core PCE has been near 2% since March 2018. This could be considered hawkish; however, the Fed said it wants the inflation rate to average 2% throughout the expansion. It doesn’t want 2% to be the ceiling.

After the previous statement, there was discussion about the possibility of changing policy from being accommodative to normal. The word ‘accommodative’ stayed in this statement which isn’t surprising because the Fed didn’t raise rates. I expect it will be changed after the Fed raises rates 2 more times this year. This timing of this change will tell us where the Fed thinks the neutral rate is.

2 More Hikes Expected By The Fed Funds Rate

As I mentioned, the bond market and the stock market didn’t react to this policy statement and decision to maintain rates. The dollar also didn’t react as the index was unchanged at $94.66 on Wednesday. This index has been in a tight range for the past 2 months. The Fed fund futures market also didn’t react much to this decision. The expected policy gained slight clarity, but didn’t move in a hawkish or dovish reaction. What I mean by that is the chance of one more hike in 2018 fell from 28.2% to 27.4% and the chance for three more hikes fell from 5.4% to 3.6%. The chance for exactly 2 more hikes increased from 64.7% to 67%. The chance for at least 3 hikes went from 70.2% to 70.6%.