The Fed Blinks: Investors Get What They Want Again

Includes: SPY, VXX
by: The Frugal Prof


Only one hike this year. The Fed is afraid of the market and appeases investors again.

The party continues in a market with no room for error. Analysis of today's rally.

The Fed's job is to take away the punch bowl. Nervousness even in a big rally.


The market has gotten the Fed to hold off on a second interest rate hike this year. Again, we see the Fed accommodating stock investors. However, even Fed officials are questioning their ability to manage the end of this unprecedented period of excess liquidity.

The Fed blinks again:

... current trading in the fed funds futures market indicates that the U.S. central bank will not be able to enact the two additional rate hikes that officials have indicated are on the way this year.

As of Thursday afternoon, market indications were for a 57.3 percent chance of a quarter-point increase in the benchmark short-term rate in June, while there's just a 41.1 percent probability that it would move again in December. The June probability was less than 50 percent on Wednesday but rose Thursday on the heels of better-than-expected 0.4 percent growth in the leading economic indicators barometer and a stock market rally.

"Things often look better when one is under the influence of free-flowing liquidity," Fisher said. "This is one reason why William McChesney Martin, the longest-serving Fed chairman in our institution's 100-year history, famously said that the Fed's job is to take away the punch bowl just as the party gets going." Dallas Fed President Richard Fisher

Even former Fed officials are criticizing the Fed.

Commercial real estate and bonds are more overvalued than at any time in history and stocks are trading at their priciest level save one period, the late 1990s before the dotcom implosion. The beer goggles, it would seem, have blinded investors to the bubble wrap that's enveloped their portfolios. DiMartino Booth spent nine years as analyst with the Federal Reserve of Dallas.

It's easy to lose sight of the incredible run the indexes have had. (NYSEARCA:SPY). Lower interest rates have helped investors for many years. And valuations are incredibly rich.

And Boston Fed President Eric Rosengren:

"…we must acknowledge that the commercial real estate sector has the potential to amplify whatever problems may emerge when we at some point face an economic downturn."

The real danger

Fed officials who have a greater sense of confidence in their predictions than is warranted:

The danger with these econometricians is they don't know their own limitations, and they have a far greater sense of confidence in their analyses than I have found to be warranted. Fed chair McChesney Martin

The consumer is still spending, but has tremendous accumulated debt from the past few years. Everything seems less expensive with such low interest rates. At some point, rates will need to rise. And the consumer will pull back.

Market Sentiment

Slight change in sentiment the last few weeks

We see the volatility come from incredibly complacent and oversold readings to a bit higher. But not much. And the S&P 500, has been essentially flat during the same time. Of course, the market was quite overbought heading into this month.

SPY 20 Day Price Returns (Daily) Chart

SPY 20 Day Price Returns (Daily) data by YCharts

Here we see the large stock market rise since the election. These returns coupled with the previous lack of volatility suggest a complacency from a stock market that is used to getting whatever it wants: either fiscal stimulus from the Fed or now, tax cuts.

SPY Annualized 3 Month Returns (Daily) Chart

SPY Annualized 3 Month Returns (Daily) data by YCharts


In fact, as the market was welcoming news of tax cuts, it was ironic that a former Fed official would question whether we could afford the infrastructure plan President Trump was proposing.

Alan Greenspan on the infrastructure plan:

"At the moment, we can't afford it," he said, arguing the U.S. has "too much debt."

Today's Action

The recent change in market sentiment towards a probability of a correction is still underway. In fact, the most interesting point of today's 175 point rally was that volatility was unchanged when all the indexes were up significantly in the morning. This was due in part because of the nasty intra day reversals we've experienced lately. The "buy the dip" investors have started to pause before buying. Even today, we had a noticeable small selloff right into the close.

One bright spot for the bulls was that today's rally was on slightly higher volume than yesterday's selloff.

As we see, the (NYSEARCA:VXX) held near its highs for the day in the morning as the S&P 500 was up significantly - a sign of increasing nervousness.

VXX Price Chart

VXX Price data by YCharts


The market sentiment has changed and in spite of a good day for the bulls, there are signs that the Fed-induced party will end. The longer the Fed appeases stock investors, the worse it could be.

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Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.