The Fed Tries To Calm Markets

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Includes: DIA, IWM, QQQ, SPY
by: Lior Cohen

Summary

The Fed, as expected, didn't raise rates this time.

The markets expect, unlike FOMC members, only one hike this year.

If market conditions persist, the Fed may not raise rates at all this year.

FOMC The FOMC meeting concluded, as expected, without raising rates and with a balanced statement that tried to keep the markets calm. Even though the Fed projected back in December 4 hikes this year, based on the last statement and the current market conditions, the markets anticipate only one hike in 2016. And if inflation doesn't pick up, there won't be even a single hike this year.

Keep calm and carry on

The Fed didn't backpedal from its December rate hike; thus, the press release couldn't be seen as too dovish. After all, if the current bearish market sentiment dissipate in the coming weeks and inflation starts to pick up again, then the Fed may be more incline to consider raising rates in the coming months. The Fed also didn't want to be perceived unaware of the current market tribulations and growing fear of a possible rescission so it could produce a too hawkish statement. The result was a statement that tried to assure the markets the Fed is aware of what's going but is still capable and willing to raise rates if data support a hike. This time, there were no dissenters to the decision.

When it comes to inflation, there is little evidence to support higher inflation anytime soon and the Fed acknowledged this:

"Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further"

But in order to balance this assessment, the Fed also maintained its notion that over the medium term inflation will start to rise again, because the impact of low oil prices on inflation won't last that long.

And even though there was support for the recovery of the labor market in the past several NFP reports, the changes in the labor market could be lagging behind, so the labor market could also experience a slowdown in the near term.

The Fed did acknowledge the rise in market volatility, and the drop in net exports and inventory investment. So it's aware that the U.S. economy could be slowing down. And inflation isn't rising. These factors compounded by the global economic woes suggest the Fed may not even raise rates this year if market conditions continue.

What about the appreciation of the U.S. dollar? Will that persuade the FOMC to revise its stance about raising rates? The U.S. dollar has rallied mostly against the risk currencies including the Canadian dollar, Australian dollar and even the British pound since the beginning of the year. While it may also sway FOMC members to reconsider hiking rates this year, I think it will play a minor role in their risk-reward calculations. For one, net exports, which are adversely affected by a stronger U.S. dollar, don't have a big impact on GDP growth in the U.S. Second, a stronger dollar isn't solely affected by monetary policy and has other factors that are out of the FOMC's hands such as other banks' monetary policies and changes in market risk.

Currently, based on market estimates in the bond market as presented by Fed-watch, the chances of rate hike by the end of 2016 have dropped from over 90% by the end of December 2015 to 67% following the release of the last rate decision.

Source: Fed-Watch

Moreover, the markets estimate only one hike by the end of the year as oppose to the Fed's initial estimate of 4 hikes from back in the December meeting.

Bottom line

The Fed tried, as it always do, keep the markets calm without sending a message that it didn't do the right decision back in December. The labor market is still showing signs of strength, but inflation remains low. And given the latest development in the markets and growing concerns over the economy, the Fed hasn't changed its policy. But if market conditions persist, and inflation doesn't start to climb the Fed may eventually have to consider keeping rates unchanged throughout the rest of the year. Finally, it may even backpedal and cut back down rates only if inflation starts to drop again to below 1%, GDP growth rate comes to a halt or labor market shows a rise in unemployment or plunge in added jobs. For more please see: The FOMC Awakens

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.