We have come to the point where Fed policy is really in a corner, and the only real way out is to distribute some pain to the markets. That has certainly been the message so far in 2016, but was certainly telegraphed over the past year or so, too. The Fed seems quite confident about the prospects for economic growth and the potential for rising inflation, enough they felt comfortable raising interest rates last month a 1/4 point – the first such move in nearly a decade. The minutes came out last week and expressed their confidence in the employment outlook, and indeed the December report on January 8 did not persuade them to believe otherwise.
Even the most dovish of Fed Governors (Evans, Brainard) believe rates should come off zero at some point in time. Though they are not in agreement with members on the number of hikes in 2016, let’s agree that potential number is still in the air. New voters in the committee include those with a hawkish view, but we are yet to hear their position other than in forecasts/projections from last months meeting (dot plot).
The last time China roiled markets was just before the September meeting, and Fed Chief Yellen among others voiced their concern over the World’s second biggest economy ripple effects from abnormal policy procedures. Further, the understanding that growth expectations need to come down, and if there is a bubble in Chinese stock markets then they are looking at a hard landing. While the Fed is always sensitive to macro events and triggers from overseas, they are clearly focused on the domestic economy. The frustration of course is the lack of ‘apparent’ inflation building within the system, as that would trigger even more hawkish policy directives.
Fed speakers have been all over the map, even some of the most hawkish ones have toned down their rhetoric. Just this week St Louis Fed President Bullard pulled back on inflation talk, while NY Fed President Dudley had mixed comments. This tells us they prefer not to guess at the unknown, leaving us to wonder how quick they will shift fed policy when necessary. Would the Fed hike rates quickly if inflation rises sharply? You better believe it, but would they be less inclined to ease quickly if their inflation/growth goals have not been met?
Meanwhile, the markets sent a resounding message – we don’t like uncertainty! So far in 2016, the SPX 500 is down a staggering 8%. Now, all the blame cannot be put at the doorstep of the Fed, but an aggressive easing policy needed to be managed better for an upcoming shift. I don’t believe that occurred, and the markets are telling us so.
It seems that markets are teetering on every word and every number, specifically the amount of rate hikes to come in 2016. Some say four, others say two. That difference, while it may seem subtle is truly the uncertainty that plagues markets currently. What really is a ‘gradual’ pace, as defined by recent Fed comments. The bond market is not convinced they have the courage to hike even at a slow pace, as these purveyors seem to believe an economic slowdown will halt any additional action. The economic data reflects their sentiment, too. The bond market is seldom ever wrong, and the Fed knows it – and are probably listening carefully.