Last Wednesday, we outlined why September's FOMC meeting was probably the most important one in over a decade. Almost a week later and we're back at square one. The Fed's much awaited interest rate decision only stoked the winds of ambiguity, adding more uncertainty to a market already gnarled by 16 months of 'liftoff' chicanery. Has the Fed lost credibility by failing to deliver on its verbiage, voting 9-1 in favor for no change in the Fed Funds target rate? Perhaps. More importantly for us though, the markets remain as confused as ever. And that's not a good thing!
Glancing back, it was in our opinion here at Business Of Finance, that the Fed would probably procrastinate on its path of tightening than hazard a gamble on the U.S. economy's resilience to the strong external headwinds that have buffeted almost all major economies in the last 4 months.
It seems that our baseline for an October liftoff might be in jeopardy. For the benefit of those that missed the event, here's one of the possible narratives which we felt the Fed would stick to (which it did):
- The Fed won't hike in September because recent negative developments across global financial markets and currencies have compounded the headwinds of a rather significant slowdown in the global economy, especially in EMs. The lack of renewed monetary easing by other major central banks such as the PBoC (highly crucial for China), BoJ (its most recent September meeting concluded with no extra QQE), and ECB means that if the Fed were to officially start tightening (even in the slightest manner) in the midst of heightened instability and uncertainty, it might be too much for the markets to bear. A September liftoff is probably going to bid up the U.S. dollar, further straining EM currencies which have already been battered hard by massive outflows from EMs and risk trades. The main reason here for the Fed not to hike in September is because current market and economy don't permit. Rather, the Fed will use September's statement to further manage market's expectations on continued progress of the domestic economy, focusing on the labor market and wages. The lack of momentum in inflation will also prevent a majority of FOMC members from voting for a September hike. The Fed will adopt a wait and see stance like it has been doing all year long.
We also said that it was important to read into the nuances of the September FOMC statement, analyze the Fed's so called 'dot plot' and last of all, tune in to Chairwoman Yellen's press conference. Having done all of these, we have come to a stoic conclusion that the most logical expectation would be to expect more of slow wading in the pond. The Fed was markedly more dovish compared to in July.
There was a deliberate emphasis on the negative external factors which we talked about. The Fed was also not fully convinced that slack in the U.S. labor market had completely diminished, noting that the participation rate has not recovered and that longer term unemployment hasn't fallen broadly enough. Inflation expectations were muted, although much of it was due to lower energy prices and seasonal factors. We've included below the full September FOMC statement:
"Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace. Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft. The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some 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 Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting."
Basically, nothing that market participants didn't expect happened. It had all mostly been baked into asset prices. The Fed Funds futures market was only discounting for a 30% probability of a September liftoff (pre-FOMC). As we currently are, Fed Funds traders seem to be centering their bets on either a December hike or one in early-2016. September's 'dot plot' seems to convey the same message; the long-run Fed Funds rate equilibrium was lowered to 3.5% in September from 3.8% in July.
The markets initially knee jerked higher (risk was well bid, U.S. dollar was offered hard). Stocks rocketed on the news and credit spreads cratered, but the real action was on the bond curve where the 2-year note saw a massive 13bp fall in yields. The entire curve traded in a bull-steepener fashion. It was not until Yellen began her press conference at 230pm EDT that (almost) everything inflected.
Yellen's mention of a possible October liftoff in her reply to one member of the audience was enough to spook markets. Stocks reversed sharply, giving back all its post-FOMC gains and actually ended lower at the close. The greenback saw a similar reaction but in the opposite direction, causing carry traders to frantically unwinding their fresh longs. We were hit on this move but managed to isolate our drawdown to a few tens of basis points. Luckily!
Don't ask us about why the markets are reacting this way. We, like many others, don't know. We have clues, but not definite answers. On how we're going to position ourselves going forward until October's meeting nears, we tend to like being neutral on the U.S. dollar, and risk. On Tuesday, we wrote on Facebook that we were bearish risk in general. Are we going to retest August's lows? It is a possibility if we continue to see risk aversion and a hope-driven rally in the U.S. dollar, but we ain't betting on it.
But remember, the number one rule in such tough markets is to preserve capital. You're already outperforming the broad market if you stayed flat or hedged when everything's going pear shaped. When correlations are breaking down everywhere, it's wise to stay liquid and be quick to act.