The Fed to the Rescue....Again

Janet Yellen and the Federal Reserve once again sang the type of tune the market had hoped to hear. The Fed's March commentary and press conference were yesterday and in the minutes leading up to their release, the S&P 500 was trading at 2,061 and down more than half a percent on the day.  Immediately upon their release, the index shot skyward and ultimately finished the day with a 1.3% gain.  Once the market had gotten its reassurance that Chair Yellen and Co. would continue to be incredibly deliberate and, yes, patient in their decision to raise rates, it was off to the races.  Stocks couldn't be bought fast enough for the rest of the afternoon.

The Fed appears to remain unconvinced of the sturdiness of the economy's footing and stated that they would like to see continued job growth along with a reasonable confidence that inflation will move back to its 2 percent objective.  Meanwhile the market had again prepared itself for the worst and priced in too much worry about what Ms. Yellen might say.  The reaction highlighted the accuracy at which the Fed Funds Futures market has displayed in predicting recent monetary policy.

This from Convergex:

Given that the Federal Reserve has as much trouble calling the pace of the U.S. economy as anyone else, it makes sense to look at the Fed Funds Futures market from the CME Group for another take on the trajectory of short term interest rates.  Here’s what prices there have to say after the Fed’s meeting and Chair Yellen’s press conference:

·The Federal Reserve will lift rates for the first time in September of this year, increasing Fed Funds by 25 basis points. 

·There is a reasonable chance of a second rate increase – also 25 basis points – at the October meeting, but more so in December.  And that’s it for 2015 – a forecast of 0.5% Fed Funds (44 basis points to be precise, indicating some uncertainty about the second move) versus the FOMC’s own 0.625%.

·In 2016, Fed Funds Futures currently price in a year-end rate of 1.25% (allowing for a little rounding – the actual number is 1.235%).  This would mean 3 rate bumps next year of 25 basis points apiece, plus a small chance for a fourth of the same magnitude.  The FOMC’s own median estimate is 1.625%. 

·In 2017, the spread between FOMC estimate and Fed Funds Futures really begins to grow.  The Fed’s dot plot currently shows a median observation of 3.125%. Fed Funds Futures register a 1.895% forecast.  To put this in context versus rates today, that is the difference between 12 rate increases of 25 basis points (Fed projections) and just 7 moves (Fed Funds Futures).

Why should you listen to the future market rather than the Fed?  The simple answer is that the marketplace has been able to predict where the FOMC was going with monetary policy long before the central bank updated its projections.  For example, Fed Funds futures for December 2015 predicted back in October 2014 that the Fed was unlikely to move more than twice in 2015, ending the year at 50 basis points.  The Fed’s dot plots from the September 17^th meeting still showed an expected year end 2015 rate of 1.375%. The market was right; the Fed moved right to where Fed Funds Futures said they should be.  It just took 6 months to get there.

All this presents us with one clear message: given that the Fed Funds Futures market is forecasting a much slower climb for short term interest rates over the next two years than the central bank itself, there is ample room for more positive surprises like the one we had today.  Both U.S. stock and bond markets – and currencies for that matter – clearly priced in too much worry about the Federal Reserve lifting rates quickly in 2015. Now, we will likely have a period where asset prices will correct to the upside in both domestic fixed income and equities.  Will that be enough to pull some money back from the crowded trade of “Long euro equities, short euro currency”?  Perhaps, given how underweighted many hedge funds may be to U.S. stocks. Even if it isn’t, we’re likely to see a follow-on rally in U.S. large cap stocks through the end of the quarter.

Dave again - Convergex presents some interesting thoughts above.  While we hope their forecast of more upside for equities in the near-term proves accurate, we definitely get the feeling that looking further out, there will be more bouts of volatility in and around Fed events as the year progresses.

Given the topic, now's a fair time to share a chart from Bespoke that we first posted a few months back.  It signals that for all the volatility that recent Fed announcements have brought, history tells us that performance for equities has been incredibly strong in the months leading up to initial rate hikes.  Meanwhile the 2nd chart gives us a longer term sense of what rate hikes have meant for stocks over the last few decades.