Digesting the Fed, Yellen vs. the market

The market has had time to settle post Janet Yellen's press conference last night, where the FOMC delivered the expected interest rate hike. This was fully expected by the market, what wasn't expected was the slightly more hawkish tone to the Fed statement. Changes to the statement worth noting include:

  • The Fed deems economic activity to have expanded moderately.

  • Job gains have moderated, but remain solid.

  • Inflation is the metric that the Fed will watch closely going forward, as it is running below target.

  • The FOMC plans to implement a balance sheet normalisation programme later this year.

  • There was one dissenter, Neel Kashkari, a noted dove, who didn't think it was appropriate to raise rates.

The Fed didn't mention anything about the delay to Washington's expected fiscal stimulus, which suggests that the Fed seems happy to push ahead with monetary policy normalisation regardless of what the Trump administration is doing.

The market reaction: calling the fed's bluff?

The tone of this statement and Janet Yellen's press conference wasn't as dovish as some expected, however, the market may be calling the Fed's bluff. The CME Fedwatch tool has seen reduced expectations for a rate hike in September to 18% and less than 40% for December.

The dollar index experienced excess volatility during the speech, but is back at the pre-Fed levels on Thursday, US 10-year Treasury yields moderated further and are 7 points lower than yesterday, and they remain significantly below the 200-day sma. 2-year yields, after initially dipping, are back at their level before the meeting. The 10-year – 2-year US yield spread also dipped lower, which suggests that the market believes the Fed will have to delay future rate hikes because of bleak economic outlook.

The Fed vs. the market

What is most interesting is the disparity with the Fed's dot plot and the Fed funds futures market. The Fed's dot plot is expecting rates to rise to a touch over 2% by 2018, however, the Fed Funds Futures and the OIS market is looking for a much milder trajectory for US interest rates, looking for just one further hike in the next year. Is the market always right? Not always, but this disparity is odd, and could play havoc with asset prices if the market has been wrong-footed and needs to play catch up with the Fed, which could see a sharp turnaround for the dollar and US yields. However, it all depends on the inflation figures, if prices continue to fall in the US then rate hikes and balance sheet normalisation could be shelved for some time.

Home Depot, General Electric and Goldman Sachs were some of the top performers on the Dow yesterday, while the sharp fall in the oil price weighed on Chevron and Exxon Mobil. The recent sell off has left the S&P 500 testing a key support level. US stocks are expected to open weaker later today, and European markets are a sea of red. Ultimately if the market expects one thing, and the Fed expects another then this could trigger excess volatility down the line.

Sterling looks vulnerable once again

GBP is faltering into the BOE meeting later today, which is expected to see no change in interest rates. Retail sales figures could give the pound a boost if they manage to defy expectations of a 1% decline. However, the squeeze on real wage growth suggests that the UK consumer is likely to be hobbled for some time, and this could weigh on GBP in the long term. GBP/USD is approaching key support between 1.2560 – 1.2630, a break below this support zone could trigger a deeper sell off back towards the symbolic post-Brexit 1.20 level.

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