The latest meeting of the Federal Reserve concluded and the expected result was announced. There would be no rate hike in June. Some of the other information could be much more interesting, though. The dot chart the Federal Reserve provides shows a much tamer outlook for interest rates. That may be a wise idea since the bond markets were demonstrating declining yields and low expectations for future rate hikes. The chart is shown below:
The new chart shows that 6 of the officials are only predicting one hike. The thing that surprised me, more than the adjustment to the chart, was the end of a response Janet Yellen provided to a question. After a fairly long question about the path of interest rates, Janet Yellen spoke about the "neutral rate" and how factors were weighing on that rate and causing it to be lower. The end of the comment, though, was what caught me by surprise:
"…It is highly uncertain for all of the dots."
Clearly, any experienced bond investor knows that the dot plot is highly uncertain. They should also know that the chart has regularly had a strong hawkish edge compared to the rates implied by the actual treasuries that investors are holding.
One of the more interesting contradictions witnessed today was bond yields falling, with the 2- to 7-year treasuries falling around 5 basis points as of this article being written. Normally, when yields are falling, you would expect a reduced expectation for a hike in rates, but that isn't what we are seeing:
Despite the decline in treasury yields, the "FedWatch" tool is demonstrating a materially higher implied probability for future rate hikes. The implied odds of the rate remaining at .50% declined from 65.6% yesterday to 52.6% today. That is still a much higher probability of rates being held flat than the 31.3% implied probability from a month ago.
The Market Loved it and Hated it
The following price chart shows movements across several investments and you can see the clear jump when the results were announced:
The chart uses mortgage REITs, including ARMOUR Residential REIT (NYSE:ARR), Annaly Capital Management (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), and CYS Investments (NYSE:CYS). However, it also uses the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).
While the equity market and treasuries are expected to have a negative correlation, every asset in the chart jumped right after 2 PM Eastern. That should be a bit of a problem because clearly the impact will not be the same for every investment listed here. For instance, the fall in long-term rates compared to the fairly weak level of gains on MBS (mortgage-backed securities) suggests that Annaly Capital Management probably lost on book value today. The mortgage REITs with a portfolio designed for lower rates and a flattening yield curve should have seen a gain on book value today.
The S&P 500 had the most interesting reaction as it jumped along with the other investments seen here and then lost all of the gains in the following 2 hours.
The Fast Decline in June
On June 1st, the 2-year treasury rate was about .91%, so the drop in rates is fairly substantial. In half a month, the rate fell by about 23 to 24 basis points.
The Federal Reserve followed the most logical course of action by keeping rates low. They still overwhelmingly view at least one rate hike as the right course of action despite the implied odds indicating that there is about a 50% chance of that hike coming to pass. The bigger challenge seems to be the relative flattening of the yield curve. The 2-year treasury yield is only .674%. If short-term rates are hiked up to .75%, it would be forcing the 2-year treasury higher or it would be pulling the short-term rates above the 2-year treasury. It seems counter intuitive for the yield curve to only become partially inverted, so there could be quite a bit of volatility coming up.
Over the longer term, I see interest rates staying low because of pressure from international markets. The treasury is not restricted to domestic investors and foreign yields running near 0%, or in the case of Japan below 0%, leaves plenty of demand for those securities.
In my view, the S&P 500 is a little rich, but lower for longer on treasury yields could easily reinforce the TINA (there is no alternative) theme. If investors can't get yield from bonds, they have a larger incentive to look for anything with a high dividend or a sustainable dividend. For the S&P 500 to climb higher, it needed to either trade at higher multiples, see GDP growth leading to earnings growth, or see earnings grow as a percentage of GDP. The further fall in treasury rates is encouraging the market to trade at higher multiples, which is anything but a long-term sustainable plan.
Disclosure: I am/we are long ARR.
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