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In yet another "most closely watched FOMC meeting," the stock market walked away a little worse for the wear, not so much because the FOMC and Fed Chairman Bernanke sounded hawkish, but because they were not unequivocally dovish.

The S&P 500 had advanced 1.5% in the two trading sessions preceding the FOMC decision based in large part on an expectation that the Fed chairman would calm the market's angst about the possibility of the Fed pulling back on its asset purchases sooner rather than later.

Basically, market participants were hoping the Fed chairman would insinuate that the market overreacted to his May 22 statement before the Joint Economic Committee that the Fed could take a step down in its pace of asset purchases in the next few meetings if it saw continued improvement and it had confidence that improvement could be sustained. He didn't do that. What he did basically was reiterate that position.

Data Dependent

In his press conference, Mr. Bernanke said it would be appropriate to moderate the pace of purchases later this year if incoming data supported the Fed's projections for continued improvement in the economy. He said, too, it was possible the program could come to an end by the middle of 2014 if substantial improvement in the labor market has been achieved.

Mr. Bernanke held out a 7.0% unemployment rate as a consensus view within the FOMC for what is meant by "substantial improvement." In our opinion, the Fed chairman didn't do the best job communicating this point initially in his press conference and was understandably pressed by the press for clarification.

In trying to clarifying things, Mr. Bernanke fell back on the position that all decisions will simply be data dependent. In turn, he took the occasion to caution listeners that they are drawing the wrong conclusion if they think the asset purchase program will definitely end in the middle of 2014, saying it all depends on incoming data.

His reminder notwithstanding, the directive and the chairman's presentation created a sense among market participants that the Fed is leaning more in favor of tapering its asset purchase program sooner rather than later. That inference could be made from the spike in the U.S. Dollar Index and long-term interest rates following the directive and during the press conference.

The U.S. Dollar Index, which was little changed before the directive was released, surged 1.0% to 81.39 while the 10-year note dropped more than a point, driving its yield up to 2.33%, which is the highest since March 2012.

The S&P 500, which was flat just before the directive was released, suffered broad-based selling pressure and ended the day down 1.4%. Not surprisingly, the spike in rates weighed heavily on high-yielding sectors like utilities (-2.3%), telecom services (-2.7%), and consumer staples (-2.0%).

The focal point in the directive is the line that says, "The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall." The focal point in the Fed's updated economic projections was the reduction in central tendency projections for the unemployment rate for 2013 and 2014.

Variable

2013

2014

2015

Longer Run

Change in real GDP

2.3 to 2.6

3.0 to 3.5

2.9 to 3.6

2.3 to 2.5

March projection

2.3 to 2.8

2.9 to 3.4

2.9 to 3.7

2.3 to 2.5

Unemployment rate

7.2 to 7.3

6.5 to 6.8

5.8 to 6.2

5.2 to 6.0

March projection

7.3 to 7.5

6.7 to 7.0

6.0 to 6.5

5.2 to 6.0

PCE inflation

0.8 to 1.2

1.4 to 2.0

1.6 to 2.0

2.0

March projection

1.3 to 1.7

1.5 to 2.0

1.7 to 2.0

2.0

Core PCE inflation

1.2 to 1.3

1.5 to 1.8

1.7 to 2.0

--

March projection

1.5 to 1.6

1.7 to 2.0

1.8 to 2.1

--

Source: Federal Reserve

Disparate Dissents

If nothing else, the knee-jerk selling interest following the directive and the chairman's press conference underscored the difficulty the Fed faces in managing the market's expectations about the future path of monetary policy.

Dissenting views within the FOMC aren't helping in that regard, either. Strikingly, there were two dissenting members at the June meeting, only they dissented for different reasons.

St. Louis Fed President Bullard dissented on the basis that he thinks the committee should signal more strongly its willingness to defend its inflation goal given recent low inflation readings. PCE inflation is currently up just 0.7% year-over-year, which is near a 50-year low (excluding the brief period of deflation in 2009) and below the Fed's lowered central tendency projection.

Meanwhile, Kansas City Fed President George maintained her dissent on concern that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.

Effectively, Mr. Bullard would like the FOMC to be more dovish while Ms. George would like it to be more hawkish. The disparate dissents are apt to raise the interest level in the FOMC Minutes from this meeting when they are released in three weeks' time.

What It All Means

The selling that occurred after the directive was released wiped out almost all of the 1.5% gain the S&P 500 registered in the two sessions leading up to the FOMC decision.

When it comes down to it, Fed Chairman Bernanke said what he has been saying all along: the Federal Reserve will be data dependent in making policy decisions. Still, markets acted as if they fear the end of unbridled policy support is near.

The perplexing thing is that stocks went down sharply with bonds. If bond prices went down on the belief the Fed is closer to a tapering decision because the economy is getting better, one has reason to think stocks would have done better or, at least, not sold off as much.

This dynamic will need to be watched carefully in coming days. The stock market can do well, and has done well, if it is confident that rising rates are a function of an improving economy. It won't do well if it thinks rising rates are a function of participants starting to think the Fed and other central banks have lost control of the situation. The performance of the cyclical sectors amid rising rates is going to be important to watch.

We said earlier this week that the Federal Reserve had the capability to calm things down at its upcoming FOMC meetings, but that there are enough Fed officials on record now pushing the need for tapering sooner rather than later that we are not sure the market is going to be as convinced as it once was about dovish-sounding signaling.

The volatility that followed a status quo policy-setting reminder from the Fed chairman is a reflection of the communication problem the Fed has on its hands.

On Monday, we published an updated market view saying it was advisable to take a more neutral approach for the time being based in part on the belief that the market will be wrestling with questions about the effectiveness of monetary policy and the enduring nature of the artificial policy support structure. The initial response to the June FOMC directive and the chairman's press conference fits neatly with that view.

The stock and bond markets wrestled with the Fed's thinking and got pinned.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Market Wrestles With Fed's Thinking And Gets Pinned