Disappointment in Who-ville

Disappointment in Who-ville. Traders expecting Powell to usher in a late Christmas rally got the Grinch, and they didn’t like it.  Markets tumbled from daily highs after the Fed raised rates and lowered hike projections next year.  “Wait”, you say, “the Fed lowered expectations for hikes next year and markets didn’t like it?”  It seems kind-of paradoxical that the Fed Chairman’s reduced expectation of next year’s hikes would be a bearish signal for the markets.  Here is why.  One word: “expectations”.  In the wake of a Powell speech a few weeks back in which he said that he believed that rates were just below a range of what would be neutral, traders began to construct a narrative that went from softening to outright dovishness.  The movement became stronger as many public figures took to the airways to give indirect advice to the Fed imploring them to hold off on rate hikes.  Leading up to the decision, probabilities of a hike, as calculated by Fed funds futures, fell indicating that some traders were betting against hikes.  The dollar weakened and gold rose ahead of the decision which are also signs that traders were betting against the hike.  To be clear, the majority were still expecting a rate hike and that is, in fact, what we got.  The language around the policy decision was almost identical to the September statement but this one made it clear that future, gradual hikes would be needed.  The statement alone should have been enough to signal to that growing group of traders who believe that the Fed is done raising rates were wrong.  Then came the Chairman’s statement followed by a Q&A session.  Powell’s statement described a Fed that sees continued economic growth with moderate inflation, although they did slightly lower their forecasts for economic growth and inflation… slightly.  The lowered forecast was the reason that they lowered the 2019 rate hike projections from 3 to 2.  Additionally, the Fed will continue to unwind its balance sheet, which means that they will continue to sell the securities that it bought during quantitative easing, which has somewhat of a tightening effect.  Finally, the Fed is paying close attention to the potential for global economic slowdown as well as how the recent selloff in stocks might affect the economy.  In all the rate hike, the statement, and Chairman’s comments were rational and consistent with the Fed’s mandate.  Equity markets were unfortunately expecting a more dovish stance and with those dashed expectations came selling. The Dow Jones tumbled more than 800 points from its daily high right before the announcement to close down -1.49%.  All of the major indices closed at or around 52 week lows.  Perhaps the most interesting reaction was the bond market’s.  As expected, 2 year yields, which have been coming down in recent sessions closed up in response to the rate hike.  Remember, the Fed controls the short maturities.  The 10 year bonds rallied bringing yields down from 2.81% to 2.75%. Remember, traders control the longer maturities and they rallied bonds because the Fed lowered growth estimates and will most likely continue to raise rates which would further slow the economy. They are, in essence, betting on a recession sooner rather than later.  The result of 2 year yields going up while 10 year yields going down is… you guessed it… a flatter yield curve.  The 2/10 yield curve went from 17 basis points to 10 basis points closing on a low for the year.

That was yesterday.  Where does that leave us?  It is not all doom and gloom!  The Fed is expecting continued economic strength with moderate inflation. That is good!  The recent tumble in stocks has made their multiples more attractive for value buyers.  I have been saying that many would-be large backstop buyers have stopped trading for the year in order to avoid further losses or losing what little they managed to make in 2018.  Once we are in the new year, those buyers will begin to position equities again, which could provide some much needed market stability.  In bonds, shorter term investors will get more yield on their investments.  That includes money markets.  There continues to be attractive yields in 5 year and under maturities.  So if you are uncomfortable with equity markets, you believe that 2019 will be another bust year, and you want to preserve capital you can use fixed income instruments and still get some decent returns on capital.

Today we will get the Philadelphia Fed survey, which details economic strength in the Philly region and it is expected to come in 15 up from 12.9 in November.  Weekly initial jobless claims are expected to be 215k up from last week’s 206k.  Finally we will get the Leading Indicators in prelude to tomorrow’s GDP numbers.  Leading Indicators is expected to be flat month over month versus last month’s growth of +0.1%.  Today’s session will feature continued debate about what yesterday’s Fed decision really means for equities.  WHILE YOU SLEPT, the Senate passed a stop gap budget plan aimed at avoiding a government shutdown ahead of the Christmas Holiday, which should add some positive sentiment to a guessing market.  Please call me if you have any questions.

daily chartbook 2018-12-20