The Fed left interest rates unchanged during its June FOMC meeting, exactly as we previewed and exactly as the markets expected. The June statement itself did not shed much new light that market participants hadn't already known. It was when Fed Chair Yellen (or what we referred to as a badass troll in our last Snippet) started speaking in the post-statement press conference, that really roiled the markets.
That said, this is the second biggest event risk gone for the incredibly busy month of June, but it didn't happen without occasion.
If you haven't already, we highly encourage you to read through our past articles published on our Snippets Journal as they provide the all important context for understand what we're about to covey in this piece.
In short, the Fed is confused, has lost a lot of confidence, and is infusing more uncertainity amongst traders and investors than ever before.
For those short on time, the gist is this (in our opinion of course):
- When the U.S. economy was actually primed and ready for a rate hike at the start of 2015, the Fed procrastinated and deliberated for almost 12 month before raising rates in December.
- As the economy and financial markets started to realize and react to a very delayed hike, financial conditions started to deteriorated much faster than the Fed had envisaged. This swayed the opinions within the FOMC itself, which translated into no new monetary policy actions YTD, only a lot of confusing rhetoric.
- By not committing to its initial path of tightening (when rates first lifted off in December), the Fed has placed itself in a very tough position. The longer it waits and observes, the more perplexing the entire landscape of future rate increases becomes. As markets and the economy don't like uncertainty, this very fact negatively impacts sentiment and actual macro, making future rate hikes increasingly risky.
- Further, as we head into the second half of 2016, the Fed will find itself confronted with even more event risks that will most likely make it less conducive to tighten into (U.S. Presidential Elections being the biggest known event risk for 2H16).
- Waiting only increases the risk of the Fed conceding to committing a policy error, which will happen if and when the Fed lowered interest rates or significantly alters its guidance and language dovishly (something we saw to a slight extent in the latest June FOMC event). Waiting too long also heightens the likelihood that the current cycle gets 'frozen in time', creating high inertia in future decisions. This forms a feedback loop which we believe markets have already started to discount for.
Surprising dovish shift
According to most analysts, commentators, and in some part the financial markets themselves, just about every aspect of the June FOMC event was more dovish than had been anticipated. It did however take some time for this realization to sink in; the realization that the Fed had nestled more closely with the doves, which is a sharp detour from what the April FOMC minutes had implied only a few weeks before.
Unsurprisingly for us though, as we had already warned of an indecisive Fed; a once credible central bank which had inherited the tendency to troll markets left, right and center.
Below, we succinctly list down the reason to why:
- First, there was no rate hike (duh). However also remember that market-implied June rate hike odds were once above 30% at their highs, only falling to 4% right before last Wednesday's event.
- Economic and inflation projections were either held constant or lowered across the board. Inflation was only projected to reach the Fed's long-term target by 2017/18.
- The all important "dot plot" shifted lower across all years. FOMC members only projected 1 rate hike for 2016 (down from 2 during April's plot). There was the entrance of a new "uber dove" who we now know was none other than James Bullard (a once very hawkish proponent for higher rates). The entire plot shifted lower by at least a notch; 2016 FF rate projections were lowered to between 0.6-0.75% (down from 0.75-0.9% in April). June's "dot plot" was the strongest indication of a dovish shift for us.
- Yellen's admission that she has no clue as to when the Fed will hike next. Yellen also said all upcoming FOMC meetings would be "live". The Chairwoman also admitted that jobs creation has certainly slowed, referencing to the huge disappointments in the April and May payroll reports, although she tried to pacify markets not to read too much into a single jobs report (we totally disagree that May's disasterous report was a one-off).
Rate hike odds & Fed credibility crushed
As we mentioned in the points above, FOMC members only saw 1 rate hike for the rest of the year. This essentially means that after its initial hike in December last year, the Fed expected to hike rates only once in 2016.
That's right, the very same Fed that so brazenly said at the start of the year, that it was firmly on the path to normalizing interest rates as the economy improved, is now only going to hike rates once this year (assuming it even does). Talk about credibility.
There 4 additional FOMC meetings left for 2016; July (no press conference), September, November (no press conference), and December. Fed Funds futures are implying the highest odds for a hike in July. July is also what the market is most focused on as the Fed isn't all that expected to hike in Septmeber as the U.S. Presidential Election will be in full swing then.
Yellen however mentioned during her presser, that the Fed does not factor in the presidential race when deciding on monetary policy. Perhaps something too convenient and unwitting for a bluff? We think so.
Other than that, market-implied rate hike odds for all 4 upcoming FOMC meetings are now sharply lower.
Markets react violently
It's rather difficult to gauge with full accuracy what the market reactions were to the June FOMC event. This is primarily due to the large number of factors which have been driving risk flows (UK referendum being one of them). In the charts below, we have documented these reactions across various asset classes to our best abilities.
Expect more Fed trolling
We maintain our stance that the Fed will remain indecisive, further loose confidence about positive momentum in the economy, and thereby adhering more to a 'wait and see' rather than a 'do and adjust' policy.
As such, we continue to expect volatile and trendless market conditions with bonds and precious metals outperforming equities. The USD will likely continue to trade in a big range, and should be expected to stage false breakouts in either direction.
Until the Fed actually acts materially, we are most likely to maintain this stance.