Fed fallout: Back to risk-off mood? Explaining what went down and what's next

The Federal Reserve seems to have cast doubts about the recovery, weighing on markets. However, this may not be an overwhelming change and things are more complicated. Valeria Bednarik, Joseph Trevisani, and Yohay Elam dive into the details, discuss the various market reactions and speculate on the next market moves and movers.

Yohay Elam: The Federal Reserve's June decision initially sent markets up and the dollar to new lows, but the mood changed swiftly and everything reversed. There is a lot to unpack here. Let's start with interest rates

"We're not thinking about raising rates, we're not even thinking about thinking about raising rates.

Valeria Bednarik: and as a side note, negative rates remain out of the picture

Joseph Trevisani: The problem for markets is three years of low rates shows how uncertain the Fed is about recovery. Equities are higher since the March low for two reasons first yes, low rates, but second and probably more important, a rapid recovery

Valeria Bednarik: The Fed is comfy where it is. But it also repeated its ready to do whatever it takes and the dot-plot showed that rates are foreseen at the current levels for at least the next two years. The dollar may have fallen initially and later recover, but they did no favor to the currency

Joseph Trevisani: If the governors think the US economy will need zero rates until 2022 then that recovery is doubtful, at least in the Fed's eyes

Valeria Bednarik: exactly

Yohay Elam: I think that equities are higher mostly on Fed support: low rates, massive QE. And yeah, the recovery is in doubt

Valeria Bednarik: equities are now suffering big from that long-term recovery perspective

Joseph Trevisani: The Fed is cautious naturally and this situation is truly unprecedented, so I am not surprised that they are uncertain, we all are. Fed liquidity is part of it but as you can see from this mornings reactions, with liquidity promised for 3 years and still, stocks fall

Valeria Bednarik: liquidity promises are only good for gold, moreover in the current uncertain scenario

Yohay Elam: Good for gold but not enough for stocks. Could the Fed have pledged even more QE? Would that make a difference for equities Or was the Fed generous enough with its pledge?

Valeria Bednarik: Somehow, I do believe that leaving the doors opened would have been enough if it weren't by the negative condiments in the statement

Joseph Trevisani: At the moment, I don't think QE is the problem or the answer.  Market sentiment does not necessarily reflect current economic conditions but it definitely reflects future conditions, it is a discounting mechanism for conditions six to 12 months out.  If the Fed is as uncertain as their rate projections tell that impacts market optimism about the recovery

Valeria Bednarik: Indeed. The Fed smashed hopes of a soon-to-come recovery and that's what we are seeing in stocks today

Joseph Trevisani: Yes. Stocks are prone to optimism so US statistics may restore the confidence but they have to signal recovery and that is by no mean guaranteed

Yohay Elam: On employment, I found the Fed's projection of a single-digit jobless rate by year-end encouraging. On the other hand, he did not seem to fully buy the optimism in May's Non-Farm Payrolls.

Joseph Trevisani: No, he did not, but surprises always need confirmation

Valeria Bednarik: Let's say that he is a wise man. A swallow never makes a summer

Joseph Trevisani: I am afraid not

Yohay Elam: Will markets wait patiently for June's NFP, or will weekly claims have a significant impact?

Joseph Trevisani: I think we can be fairly certain of one item. If the economy does not continue to reopen, job numbers will not improve

Valeria Bednarik: We all know that April and May numbers would be terrible, that's priced in. We hope June ones are better and the first sign of an economic comeback.  My take is that the June NFP will have a more significant impact

Joseph Trevisani: Agreed, but we don't get those figures for three weeks,  These days that is a very long time

Yohay Elam: Yep, three weeks can be eternity. In March, three days were a lifetime

Joseph Trevisani: Initial claims are moving in the right direction, but except for continuing claims three weeks ago there have been no positive surprises

Yohay Elam: Regarding the reopening, consumer behavior makes a difference, especially in the US, where consumption is central and especially so in recent years. Perhaps retail sales will serve as the next major market mover?

Joseph Trevisani: Yes, I think so. It dropped 16.4% in April and is forecast to return 7% in May. If it is much stronger, then it will restore confidence in the recovery

Valeria Bednarik: umm, that may be stretching things too much. Of course, at some point are meant to bounce, but as it happens with the employment report, it would take 3-4 months of encouraging numbers for it to have an effect on the market

Joseph Trevisani: I meant to restore confidence for equities

Yohay Elam: Recovery. The Fed's forecast is for a drop of 6.5% in GDP this year and a bounce of 5% in 2021

Valeria Bednarik: an optimistic number, that for this year

Joseph Trevisani: Yes, you are right

Yohay Elam: -6.5% may sound optimistic, but not returning to pre-pandemic output in the next 18 months sounds pessimistic. Perhaps that also contributed to the downfall?

Joseph Trevisani: The range of estimates is wide. Atlanta has -48.5% for Q2, NY Fed has -25.5% and -12% for Q3

Yohay Elam: Forecasting has become super-extra-hard in coronavirus times

Valeria Bednarik: yups, indeed the main reason for the slump is the longer-term pessimistic view

Joseph Trevisani: Yes, I think the markets expected more optimism from the Fed.  The Fed's initial response in early March before any economic statistics were available gives them credit. They were correct in anticipating the debacle. Or maybe the Fed just does pessimism better than optimism. Economics is probably not called the Dismal Science for nothing. Consumer sentiment is affected by the news flow, and I don't know how you would incorporate that into a GDP equation. And we have been a bit short on positive news

Yohay Elam: Had the Fed been more optimistic, it would not justify pledging so much support, would it? Some would have feared tightening. I think the Fed had a hard balancing act

Joseph Trevisani: Yes, very

Yohay Elam: Powell is much more of a straight-talked in comparison to his three predecessors

Valeria Bednarik: no doubt about that

Joseph Trevisani: Yes. It's interesting. I saw one journalist referring to Yellen as an uber-dove yesterday. I guess he forgot that it was Yellen's Fed brought rates up from the zero bound

Yohay Elam: Yeah. Without causing chaos. At some point, it seemed the Fed would never raise rates

Joseph Trevisani: Yes. Yellen does not get the credit her Fed deserves. Compare to the trap the ECB is in.

Yohay Elam: and the BOJ. Draghi already halted QE but never raised rates

Joseph Trevisani: Yes, poster child for an ineffective monetary policy. The economic problems for both economies are largely outside of the reach of monetary policy

Yohay Elam: After the Fed, will the focus shift back to fiscal policy? Or perhaps speeches from Fed officials? Coronavirus stats, reopening decisions, Sino-American relations, economic data, so many things

Joseph Trevisani: Perhaps fiscal policy but mostly economic statistics and the potential second wave of the virus

Valeria Bednarik: you forgot Brexit...

Yohay Elam: The Bank of England is the next central bank to announce its decision

Joseph Trevisani: Yes, but Brexit relates only to the pound

Yohay Elam: They have contemplated negative rates

Valeria Bednarik: Yups, but I mean, the "usual" problems we had over the last years. Still, I don't see that happening anytime soon, as I don't see the pandemic ending anytime soon

Joseph Trevisani: The institutional temptation to negative rates always amazes me. Are there any examples that they work? That they promote economic growth. It seems the evidence is the opposite

Yohay Elam: The Fed has clearly shoved it out of the agenda. 

Joseph Trevisani: There is, apparently, a bureaucratic imperative to do something, anything

Yohay Elam: Markets were thinking about YCC while speculation about negative rates is out. About Brexit, I agree it will be with us for a long time, but coronavirus outweighs Brexit for the UK. It will be hard to disentangle the economic impact of whatever Brexit outcome from the impact of the disease

Joseph Trevisani: That is true. The viral impact is widespread, far beyond the public health sphere

Valeria Bednarik: In the meantime, the dollar will maintain its weak tone? Only posting modest gains in risk-off spikes?

Joseph Trevisani: I think so. Its two possible drivers, a return to risk-off pricing or an accelerating US recovery are absent

Yohay Elam: I think we will see a bit of risk-off favoring the dollar, but more divergence between currencies. The euro is outperforming the pound and the loonie is beating the Aussie, each currency with its story

Joseph Trevisani: Until one or the other resurfaces, a trend is unlikely with a bias lower.  It not quite full-on risk-on but a default. I agree with the divergence

Yohay Elam: Perhaps if we get a long list of depressing news, it will turn into a full risk-off mood

Valeria Bednarik: The economic recoveries may take long but I don't see a long list of depressing news coming up these days. Probably Brexit is the one with more chances of being a risk-off factor, but as Joseph said, it will hurt mostly the Pound