The Fed Takes the Path of Least Resistance…Again

“Just because we removed the word patient doesn’t mean we will be impatient.” – Fed Chair Janet Yellen

A reporter from the USA Today emailed me yesterday to ask how the bond and stock markets would react to three different potentials scenarios related to the Fed meeting today. The scenarios were as follows:

  1. Fed DROPS ‘patient’ language from statement AND says on track for June rate hike
  2. Fed DROPS ‘patient’ language from statement BUT pledges patience on its rate-hike plans
  3. Fed leaves ‘patient’ language IN statement.

The response to the first scenario, which didn’t happen, was easiest to predict. Under that unlikely scenario, I said that I thought stocks would sell off significantly and that bond yields would rise (prices would fall). Why? Because the weaker economic data we’ve been getting over the past several days had led many to conclude that the Fed will defer its initial rate hike until later in the year (or perhaps beyond). Based on this expectation, emboldened investors bought stocks and bonds ahead of the Fed meeting. But if the Fed were to surprise the market by committing to a June rate hike (based on an improved economic outlook), these recent gains would have quickly evaporated. This is another way of saying that nearly six years into the economic recovery, good news is still bad news (and vice versa) for stock investors.

But alas, this isn’t what happened. In a replay of the same old boring movie, the “Fed put” proved to be the right bet once again and scenario #2 was the correct answer. The Fed did drop the word ‘patient’, but it took great pains to assure us that it indeed remains patient. The reaction was a dramatically positive intraday reversal of well over 300 points in the Dow Jones Industrial Average. Makes you wonder what would have happened if they kept the work ‘patient’ in the statement!

Yes, the Fed predictably punted once again, saying that “the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” The Fed also said that “information received since the FOMC met in January suggests that economic growth has moderated somewhat.” Wow. Those aren’t exactly the words of ultra-confident central bankers. We knew the Fed was a little worried about low inflation, but now, in the words of CNBC’s Steve Liesman, “even the labor market doesn’t meet the Fed’s standard for a rate hike!” Pretty surprising if you ask me. But it’s not surprising that investors are once again cheering the news that the economy is flailing.

What’s really going on here? As we discussed in previous Market Commentaries, the Fed has become uncomfortable with the disinflationary effects of 1) a surge in the US dollar, and 2) the rapid drop in oil prices. Each of these trends, which incidentally are not independent of each other, has caused the various inflation indicators to drop significantly below the Fed’s target of 2.0%. And while the Fed believes these disinflationary pressures will ultimately prove to be transitory, there is no guarantee this will be the case. Weak economic growth outside the US is clearly having an impact on US economic growth. Reflecting the growth differentials (among other factors), the dollar has surged in value relative to the other major currencies. The surge in the dollar is negatively affecting our trade balance, which will be a drag on US economic growth for the foreseeable future. At the same time, Chair Yellen said in her press conference that despite the rapid decline in the unemployment rate, we have not seen wage growth improve. And finally, the Fed also mentioned that “the housing sector remains slow” despite mortgage rates that have seldom been so low.

As one might expect given the aforementioned headwinds on economic growth, the FOMC reduced its projections for 2015 GDP growth. The new predicted range is 2.3%-2.7%, down from the prior expectation of 2.6%-3.0% (despite a reduction in the expected unemployment rate at year-end to 5.0%-5.2% from the prior range of 5.2%-5.3%). Reflecting the Fed’s more subdued growth expectations, the weighted average forecast for the Fed Funds rate at the end of 2015 decreased by 36 basis points to 0.77% from 1.13% at the December meeting.

Should we have expected anything less from the Fed? The answer is NO! The Fed remains the biggest factor driving the capital markets by far, and we remain stuck in this endless cycle of financial repression that very likely won’t end well. A strategy of inflating asset prices in an effort to fine-tune the labor market and the economy at large is fraught with peril. The Fed is doing more harm than good at this point, and encouraging further gains in asset prices through easy money is likely to backfire at some point.

Having said all this, today’s developments should carry some important lessons for investors. First, the dramatic and unexpected reversal in stock prices should serve as an example of why long-term investors should stay invested and not try to time short-term moves in the market. Second, despite much argument to the contrary, the US economy cannot completely “decouple” from the rest of the world (or vice versa). For better or worse, we’re all in this together.

Remaining defensive in a predictable world.