The Fed: The Market Is Calling Your Bluff

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Moshe Shamouilian
Summary

Treasury rates jumped significantly post Sep 26th Fed speach.

Market has not priced in 2018 rate hikes.

Will Jerome Powell really stick to Yellen's path?

On September 26th the Fed made one of their most important statements all year:

... given that monetary policy affects economic activity and inflation with a substantial lag, it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.

This simple statement was the Fed's last-ditch effort to restore their credibility and ensure the market understands the Fed's commitment to "normalize" rates. While the 2 year Treasury rate had stayed in a narrow range, the reaction to the statement saw the 2-year rate spiking over 12% to levels last seen in 2008. The 10 Year Treasury rate's reaction has also been quite pronounced, as it snapped a prolonged decline going back to March.

Chart 10 Year Treasury Rate data by YCharts

Why was that statement so crucial? The market had lost faith in the Fed's rate hike given that core inflation has not reached the 2% target, and is not expected to reach the target for a while. Using Investing.com's Fed monitoring tool, you are able to see the how the market is pricing in future rate hikes. The chart below is the evolution of the market's view on an additional rate hike in December. Up until the middle of September, the probability of the December rate hike was hovering near 30%; however, post-Yellen's statement, the probability of the rate hike quickly jumped to almost 80% and stands now at 100%.

However, at the same time, the main indices continued their amazing performance.

Chart ^SPX data by YCharts

Now here is where it gets interesting! The market bought into the Fed's rate hike plan for 2017 but has yet to truly price in 2018 rate hikes.

As of today, Nov 9th, the probability of the Fed raising the rate to 1.75-2.0 is only 16%. While based on the Fed's projection the median for the fed funds rate is 2.1% by the end of 2018. Assuming that the Fed only raises 25 bsp per meeting, the Fed will have to convince the market that the rate hikes in 2018 are going to happen!

Jerome Powell: A Vote for continuity?

Short answer: This FT article sums the appointment well:

The 64-year-old Mr Powell is a centrist on monetary policy who largely adhered to Fed chair Janet Yellen’s dovish approach to interest rates — something that officials believe worked in his favour as Donald Trump considered candidates for the job. The appointment, which is subject to Senate confirmation, will be welcomed by Wall Street, where the Fed’s incremental approach to reducing its stimulus programmes has helped foster surging asset prices and little tightening in financial conditions.

The market is counting on Powell to be even more dovish than Yellen. Since the appointment of Jerome Powell to replace Yellen, the probability of the rate being 1.5-1.75 by the August 1st, 2018 meeting has topped at 40%.

Conclusion

Over the first few months of 2018, the Fed will have to make their rate hike plan 100% crystal clear. The one thing the market hates more than higher interest rates is uncertainty. If the Fed does indeed begin to lose their credibility, the ramifications will be disastrous. And if the Fed fall behind their plan they risk triggering a recession when forced to quickly raise rates!

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.