Warning: Hawkishness Ahead

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by: Tim Duy

The Fed has proven very dovish since their December rate hike. Tumultuous financial markets gave the Fed doves the upper hand, leading the Fed to pause in its "normalization" campaign and cut in half the expected pace of rate hikes this year.

But be prepared for the tenor of the song to change. I would not be surprised to see doves shedding their feathers to reveal the hawk underneath.

Boston Federal Reserve President Eric Rosengren exemplifies this shift. Twice in recent weeks, Rosengren, typically considered a notable dove, warned that financial markets were underestimating the odds of rates hikes this year. The Fed made clear in the dots they expect at least two hikes; financial markets anticipate only one.

What is going on here? First, as I said earlier this week, the Fed is not happy that markets wrote of a June rate hike. I am wary that the data arrives to support a rate hike, but don't think the Fed is ready to give up on that hike just yet.

One thing to remember is that the Fed still prefers to hike early and slowly if possible. They are more aware of the asymmetric risks they face than in December, and hence recognize that they should error on the side of looser policy in an uncertain environment. Hence skip March and April. But once the risk subsides, they will return to old habits. And old habits in this case mean a return to quarterly rate hikes.

My assumption is that they want the option to both hike quarterly and hike three times, should the economic environment shift. That means they are thinking June-September-December is a possibility still (the dots are just a forecast, they are not committed to just two rate hikes). So they really need to keep the June option open, otherwise they run a greater risk of bunching up the next few hikes. Which means they want to raise the odds of a June hike to something closer to 50-50. The recent FOMC statement, in which declined to mention the risks, was an early signal of the direction they want to move.

And note that not mentioning the risks at all is arguably a de facto assessment of balanced risks in the world of central banking. My suspicion is the Fed feared that actually saying "balanced" would be a stronger indicator than they wanted to send. But they still said a lot by saying nothing at all.

Now, why should the Fed have a change of heart? Didn't Federal Reserve Chair Janet Yellen just go all dovish? How can they change their story so fast?

They can change their story within the scope of six weeks. Just like they did from the December to January meetings. And they have the one good reason to change the story: The dramatic change in financial market conditions.

The tightening in financial markets during the winter was the proximate cause of a more cautious Fed. The data didn't help, to be sure, but more on that later. The combination of a surging dollar, collapsing oil, and a stock market headed only south signaled that the Fed's policy stance has turned too hawkish, too fast. The Fed relented and heeded the market's warnings.

But things are different now. US stock market rebounded. The dollar is languishing. And oil is holding its gains, despite disappointment with the lack of an output agreement.

This improvement will not go unnoticed on Constitution Ave. Even among the doves.

That brings us to the data story. To be sure, incoming data this quarter has been lackluster. But that might soon be changing. Gavyn Davies, writing for the FT (sign-in required), is spinning a more optimistic tale:

The Fulcrum nowcast suggest that US activity growth fell continuously from the beginning of 2015 to February 2016, by which time it was around 1.0 per cent. However, in a potentially important change, the nowcast moved sharply higher in March and April, and it is now fluctuating around 2.0-2.5 per cent. This change was rapidly reflected in the prices of US risk assets, which recovered slightly before, and then along with, the daily US nowcasts.

Financial markets do not wait for quarterly GDP to be published, and they often ignore it altogether when it does finally appear. We prefer to ignore the noise from quarterly GDP, while focusing attention on the underlying activity factor that is driving the business cycle.

He includes this picture:

Fulcrum

Be forewarned: The Fed is primed by financial markets to change their story. If the data shifts as well, they will be looking hard at June. I don't think the data will line up in time, but the possibility should be on your radar. There is a lot of data between the April and June meetings - two releases of many critical indicators. Too much data to be complacent.

Bottom Line: Remember, the Fed can turn hawkish as quickly as it turned dovish.