The Fed Speaks, The Market Ignores

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Includes: GLD, SPY, TLT, UUP
by: Eric Parnell, CFA

Summary

The U.S. Federal Reserve completed its latest Open Market Committee meeting on Wednesday.

The Fed wanted to kick the door open for the possibility of another quarter-point interest rate increase in September.

The market decided to hear an entirely different story.

The U.S. Federal Reserve completed its latest Open Market Committee meeting on Wednesday. The Fed's objective coming out of the meeting was seemingly clear - they wanted to kick the door open for the possibility of another quarter-point interest rate increase in September. Notably, the market decided to hear an entirely different story.

Managing Market Expectations

The Fed has demonstrated itself to be hyper concerned about what investors, capital markets in general and the stock market in particular, are thinking and feeling at any given point in time. The priority, particularly during the post-crisis period, has been to try and explicitly telegraph in advance exactly what the Fed might be even considering doing with monetary policy in the future just to make absolutely, positively, super duper sure the markets are not surprised in any way when they finally decide to act.

While I completely disagree with this approach in overseeing what are supposed to be "risk assets" in a "free market" system, since I am not the Chair of the Federal Reserve it does not matter what I think, only how I respond in response to what they do. And although the "shock" associated with the recent 'Brexit' episode should have provided at least some reassurance that investment markets in 2016 and the adults that populate them are much tougher than realized, the Fed clearly remains inclined to coddle and soothe markets, no matter what the long-term costs.

But one of the ongoing challenges associated with the Fed's effort to try to communicate everything and anything to capital markets in the most careful possible way is that the market just seems to keep missing the point of what it is trying to say.

Take the events surrounding the latest FOMC meeting that just came to completion on Wednesday. Back as far as the beginning of last week, we were seeing articles in the Wall Street Journal proclaiming that "a rate increase could come as early as September if economic data holds firm." Make no mistake, these articles in the WSJ are not based on wild speculation from some fringe source, but instead are there for the reason of helping to get the Fed's messaging out. And the article headline from today's WSJ, not long after the latest FOMC meeting adjourned, even more explicitly confirmed the Fed's intent - "The Fed Leaves Door Open to Move as Soon as September."

In short, the Fed's primary objective coming out of its latest July FOMC meeting was to alert the market that the potential for a September rate hike is absolutely on the table.

Is This Thing On?

Click to enlarge

So how did capital markets respond to this supposed alert by the U.S. Federal Reserve? Capital markets are supposed to be predictive mechanisms that fully and efficiently reflect all available information, right?

Put simply, the market probably reacted in the complete opposite way of what the Fed might have expected. Stocks (NYSEARCA:SPY) ended the day largely flat, which from the Fed's perspective is good because they don't want to shock the markets. But Treasuries (NYSEARCA:TLT) and gold (NYSEARCA:GLD) rallied sharply. Now it could be argued that these more safe haven categories might have been driven higher behind expectations that higher interest rates could slow the economy. But debunking this notion was the fact that the U.S. dollar (NYSEARCA:UUP) traded measurably lower on the news, suggesting instead that other forces were at work.

Taking one step further, market expectations for a Fed interest rate increase in September and December as measured by the CME 30-day Fed Fund futures prices had not risen by the end of the trading day. Instead, they actually declined. For September, the investor perceived probability for a 25 basis point rate increase at its next meeting in September fell by 1.5 percentage points from 19.5% on Tuesday to 18.0% on Wednesday. Moreover, investor expectations for at least one interest rate hike by December did not rise but instead fell by a whopping 9 percentage points from 51.5% on Tuesday to just 42.5% on Wednesday.

Put simply, the Fed clearly set out to accomplish something on Wednesday, and they have at least in the initial hours following the conclusion of their meeting ended up with the exact opposite result.

Mission NOT Accomplished

Now it is worth noting that the first few trading days following the adjournment of an FOMC meeting are filled with lots of noise. In nearly all cases during the post-crisis period, it takes anywhere between two to seven trading days on average, all else held equal, before the market finds its true course in response to what the Fed has said or done coming out of its meeting.

But the fact of the matter remains that the Fed did not get the outcome it was clearly seeking. And one of two possibilities explains the reason why.

For one, perhaps the market was just not paying attention to what the Fed was trying to say and heard something altogether different.

On the other hand, perhaps investors simply do not believe that the Fed will actually follow through with a rate hike in September.

It is on this second point that I would share common ground with investors. The Fed has threatened the possibility of raising interest rates so many times in the past, yet they have only followed through once with an actual rate increase. After all, weren't we supposed to get four rate hikes in 2016? Not so much, it turns out. So the market can be forgiven for looking past what the Fed was trying to say today, as their reactive shifts in policy direction throughout the post-crisis period has had a cumulative effect in damaging their credibility.

The Fed Still Wants What It Wants

It has long been said that investors should not fight the Fed. And while I don't always agree with this notion, as fighting the Fed worked out pretty well for a while both when the tech bubble burst and when the financial crisis unraveled, I do believe it applies in this case. For it does not matter at the end of July whether the Fed actually ends up following through or not with a rate hike coming out of its September meeting. Instead, what matters to the Fed is that the market believes with a more meaningful probability closer to 40% to 50% that it may hike rates in September. The Fed may or may not actually do it in the end. But it wants to make darn sure that the market is clear on the point that it might happen in September if they so choose. No surprises, right?

One thing that has seemed to increasingly frustrate the Fed particularly during Janet Yellen's tenure as Chair is when the market blows off the message that it is trying to deliver. As a result, investors should not be surprised in the coming days if monetary policy makers start taking to their podiums to more explicitly and figuratively clunk investors over their head with the repeated signal that a rate hike in September is indeed on the table at a much better probability than nearly a one in six chance.

Bottom Line

The Fed has got more work to do in following through on their messaging for September. They want the market to know that a rate hike is really on the table at its next FOMC meeting. And the process of reinforcing this idea is likely to induce some increased market volatility as this message finally gets across. As a result, it is reasonable to anticipate the potential for a downside movement in stock, bond and precious metals prices as well as a boost in the U.S. dollar at least in the short term as the reality of what the Fed might want to do in September finally sets in.

For if the strong stock rally post 'Brexit' was driven by the belief that the Fed would be on hold for longer, it is reasonable to think that a good portion of this rally if not all of it may be set to be given back at least in the short term if it turns out that the Fed is now thinking of raising rates much sooner than the market is currently expecting. And this may be particularly true given that corporate earnings have deteriorated over this same period of time over the past month.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT, PHYS, USDU.

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.

Additional disclosure: I am long selected individual stocks and also hold a meaningful allocation to cash.