The Fed Doesn’t Surprise, but the Market Reacts Anyway.

As expected, quantitative easing (QE) was tapered another $10 billion last week and the Fed dropped its earlier guidance that it might start raising the Fed Funds rate when unemployment is 6.5% (confirming that it will wait longer than that, since we’re almost at 6.5%).

The U.S. stock market sold off sharply on this news (even though the outcome was widely expected), then rallied the next day.  Some observers think it was computer algorithms that (seeing unexpected hawkishness) triggered the selling; the dip was a buying opportunity.  The bond market moved to price in a stronger economy and faster pace of Fed Fund rate hikes.

Forward Guidance:  Looking at a Broad Range of Data

As it has stated previously, the Fed will remain data driven, but will avoid focusing on only a few metrics; rather, it will be more holistic and exercise more judgment.  It will now wait “until the outlook for the labor market has improved substantially in a context of price stability” before it starts lifting the Fed Funds rate.

  • In the press conference, Fed Chairman Janet Yellen suggested that the first Fed Funds rate increase might arrive six months or so after QE ended (thus Q2 2015) . . . this was interpreted by some as slightly hawkish, but also as a “rookie mistake” ‑ a veteran would have mumbled and evaded the question.
  • The FOMC members’ latest individual forecasts suggest most expect the Fed Funds rate to reach around 1% by year-end 2015; most estimates for year-end 2016 are between 2% and 3%.  As context, most think the “longer run” normal is 3.5-4%.

Commitment to 2% Inflation Reinforced

The statement also suggested a slightly greater emphasis on getting “inflation moving back toward its longer-run objective” (of 2%). The vote was 8 to 1; the dissenter wanted an even stronger commitment to getting inflation up.

Better Weather Showed up in the Data

The weather was better in February, and we saw broad evidence of its influence.  February industrial production was stronger than expected, with manufacturing the key driver (if utilities had been the big positive, it would be less bullish, since high heating bills don’t signal economic strength).

wardwell week ended 3.21 chart

  • Capacity utilization ticked up from 76.6 to 76.8.
  • The NY (Empire State) Fed survey signaled continuing but slightly softer growth with inventories building; the Philadelphia Fed survey was much better, moving from -6.3 to +9.0 as the weather improved.
  • The LEI (Index of Leading Economic Indicators) rose, consistent with moderate growth ‑ some weather drag, perhaps some non-weather concerns as well.
  • Labor data was encouraging. Initial unemployment claims for the week ending March 15 came in at 320k – that suggests cause for optimism, since the week containing the 12th of the month is the week whose data drives the monthly jobs reports.

Last Week in the Capital Markets

  • Equities: The MSCI Europe Index returned a market-leading 1.9% as the Ukraine situation appeared to de-escalate.  The S&P 500 Index returned 1.4%.  Within the S&P 500, Telecom Services, Financials, and IT were leaders.  Only Utilities failed to post a positive return for the week. MSCI Emerging Markets was up 0.9%; The MSCI Japan Index was weak again, returning -1.6% for the week.
  • Bonds:  The belly of the Treasury curve shifted dramatically in the aftermath of last week’s Fed meeting: the one-year Treasury yield rose only 2 basis points (bps), but the two-year yield rose 9 bps and three-year yield rose 17 bps.  The 10-year Treasury yield rose 10 bps to 2.75%; the 10-year TIP yield rose 13 bps to 0.61%.  High yield spreads declined 20 bps (off cycle lows) to 376.
  • Commodities: WTI oil was up a bit less than 1%; gold was down 2-3%.
  • Currencies:  The dollar gained about 1% against the Euro, Yen, and Yuan.  In the case of the Euro and Yen, most of the move followed the Fed-speak (markets had expected a more dovish tone).  The People’s Bank of China (PBoC) continued to drive the Yuan down, widening its daily trading range from 1% to 2% and continued to lower the range’s midpoint.

Housing Data: No Crash, No Boom

  •  Housing starts met expectations, while permits were better than expected.
  • The NAHB index (a leading indicator of new home sales) didn’t bounce back after January’s drop.  There’s a marked scarcity of first-time buyers and foot traffic.
  • Existing home sales were essentially flat month over month (m/m) they’re down 7% year over year (y/y).
  • The median home price ($189k) is up 9% y/y, but that will rise if there are fewer distressed sales ‑ it’s not just rising prices, it’s fewer bargains.
  • Mortgage applications for home purchases are down 15% y/y.  Prices are reducing demand.

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About Sam Wardwell

Sam Wardwell, CFA, is Senior Vice President and Investment Strategist at Pioneer Investments. He joined Pioneer in 2003.
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