Well, I sure whiffed on that call. Although I did not think the Fed would raise rates at yesterday’s FOMC meeting, I was convinced they would take the opportunity to cement in expectations for a September hike. The market was pricing an approximately 50% chance of a 25 basis point rise in Fed Funds by October (first clean month of Fed Fund futures after the mid-September FOMC meeting). After yesterday’s meeting this probability declined to 40%.
Not only did the Fed not manage to build in any certainty for a September hike, but they even failed to maintain the market’s expectations of the previous existing pace of tightening. The market interpreted yesterday’s events as the FOMC committee being further away from tightening than was previously discounted.
I am not sure this was the message the Fed was trying to send, but this was the message that was received. You might argue about what the Fed wanted to do, but you can’t argue about what the Fed did.
Have a look at the US 2 year yield and the US dollar index:
And as would be expected from a dovish Fed, risk assets went bid. Even the much hated gold got a bid:
There can be no denying the market believes the FOMC committee is further away from raising rates than previously feared. Although I do not understand why the news was greeted so dovishly, the market’s reaction to the news often says more than the news itself. The most obvious answer is there were more guys like me that were expecting the Fed to be more hawkish. When the FOMC committee once again failed to commit to higher rates, the Gundlach view of the “Fed will never raise rates” was embraced.
If I were Yellen, I would be extremely worried about yesterday’s reaction to the FOMC committee meeting. The market increasingly believes the Fed officials are a bunch of drunk buffoons that are always coming up with a reason to not hike rates. Every time it seems the Fed is close to raising rates, they push the bar for liftoff a little higher. They keep talking a good game about hiking shortly, but the market is increasingly not believing them.
If this trend continues, it well might be that when the Fed eventually hikes rates, there is little market expectations built in. The market will have discounted little chance of a hike because of the lack of Fed credibility. This will make the reaction much greater than it should otherwise have been. The most anticipated hike in the last thirty years will be the biggest surprise.
Green light for risk on?
There is no sense arguing with the market right now. The Fed has given the green light to party for another couple of months at least, so risk on trades are back in vogue. It has given gold a decent bid as we are now up $22 overnight. The US dollar is selling off, and don’t forget how crowded the long side is with fast money.
The Fed has agreed to not choke off liquidity at least until autumn (ever?), so all the worries about the coming global deflationary collapse seem to be put on hold.
My suspicion is the fast money is long US dollars, short gold and other commodities. They are underweight emerging market equities and overweight developed markets like Europe and Japan that are engaged in quantitative easing. They were convinced the coming US tightening cycle would bring the entire global economy to a screeching halt.
All these trades are coming off quickly. The wind down won’t be a one day affair. Watch for the US dollar to continue to sell off, gold to stay bid, and emerging market equities to outperform developed markets.
I also think this increases the chances of the Fed losing control of the long end of the bond curve. Although bonds have rallied on the dovish news, the long end is a sale into strength. The Fed is irresponsibly making the mistake of leaving rates too low for too long. It is ironic because at yesterday’s FOMC press conference, a reporter specifically asked Yellen about the previous Fed’s slowness in raising rates during the 2005 tightening cycle. Showing no mercy, Yellen slammed the previous Fed, saying that in hindsight they should have raised rates more quickly. Of course the previous Fed made a mistake leaving rates too low for too long, but there is no way she is making the same mistake today…
Thanks for reading,