Why this could have been the Fed’s last rate increase

If you look at markets today, they are on full strike. The Fed may have reduced guidance. But that was clearly not enough to assuage market sentiment. Across a wide cross-section of markets, conditions have continued to tighten this morning in the wake of the last Fed rate hike yesterday. I think this makes a March rate hike less likely to occur. In fact, this last hike may end up being the Fed’s last. Some comments below

What I’m seeing in markets today

There are a number of places of weakness today. Below is a partial list:

  • After an up day yesterday, oil is down 3% again today, with WTI trading at $46.62 and Brent at $55.39
  • Global equity markets are shedding value. Most Asian markets were down including the Nikkei 225, the China A50, and the Hang Seng. In Europe, the FTSE is at a two-year low and all the major bourses are down.
  • In currencies, the dollar is getting whacked, which is a strange reaction to what is supposed to be a Fed that disappointed by being to ‘tight’. All of the major currencies are up against the USD.
  • In US government bonds, we now have a full inversion in the middle of the curve, with the 2-year yield above the 3-year and the 3-year above the 5-year. The 2-10 spread is now less than 11 basis points.
  • In other bonds, the iShares Global High Yield Corporate Bond Index was down yesterday, meaning that as Treasuries rallied, riskier bonds sold off, a clear sign of a flight to safety. That index (GHYG) is at its lowest level since the shale oil bust in 2015, having rolled over since mid 2017.
  • In European government bonds, yields are down across the board. The 10-year Bund is trading at 0.235%. The British 10-year Gilt is down to 1.269%. And the Italian 10-year is now well below 3% at 2.75%. These are all signs of a flight to safety.

There are positives though. One positive here is that the flight to safety hasn’t metastasized into a differentiation among European sovereign debtors. For example, Italy is holding up rather well. And this drop in yields is welcome news. I see peak dollar as another positive sign because my view had been that the dollar would peak due to the Fed turning more dovish. And that seems to be happening.

So why is the market reacting so harshly?

I was looking at Tim Duy’s latest Fed Watch piece. And I think his reaction to the Fed’s policy statement gives you a sense of where the market’s head is right now. Here are a few choice quotes (with the emphasis in the original):

  • “Equities tumbled and the yield curve flattened further as Federal Reserve Chairman Jerome Powell’s press conference wore on. I can’t imagine that the Fed is pleased with this outcome. That said, they have only themselves to blame. The Summary of Economic projections continues to maintain an unnecessarily hawkish bias that only allows Wall Street’s worries about growth to fester.”
  • “The Fed was more hawkish than I anticipated in that they did not drop entirely the “further gradual increases” language in the FOMC’s statement. I had expected them to create more uncertainty about the future; they chose instead to reinforce their expectation that rates would continue to rise.”
  • dovish shifts failed to offset the fundamentally hawkish aspect of the forecasts: The forecasts continue to say that central bankers anticipate they will continue to raise rates until the Fed turns policy from accommodative to restrictive. It’s not just the median; the pattern of dots imply the same.”
  • In a risk management framework, the Fed would have been wise to skip this meeting and put January in play. By not doing so, I fear the Fed may flip uncomfortably close to my alternative scenario – that they continue hiking until something breaks.”
  • Bottom Line: The Fed hiked rates in a very predictable fashion. It might be a decision that quickly comes back to haunt them.”

My synopsis here is that the market now thinks the Fed will continue to raise rates until it inverts the curve and the credit cycle completely breaks down. So, rather than yield to the market’s signal, the market believes the Fed will continue on a path that ends in recession – as it always has in previous economic cycles.

My view

I am not quite there yet. I was actually encouraged by the Fed’s backpedaling on rate hike guidance for 2019. And I think that their guidance means that a March rate hike, which seemed almost like a done deal a month ago, is in serious question. The concept that Pedro da Costa floated a month ago that the Fed could be done hiking is now real. But instead of hiking again in March and being done, the hike we just had could be the Fed’s last one.

It all depends on the data, of course. And positive data is actually bearish for equities and other risk assets here. That’s because the more positive the data are, the more likely the Fed is to stick to its timetable of rate hikes, even in the face of an inverted yield curve. Nevertheless, the fact that the Fed adjusted guidance as a result of the recent tightening of financial conditions tells you they are listening to market signals.

For me, the real test will be the January data to come, because that’s when we get to see how the US economy fared in Q4 and the holiday season. Until then, expect continued volatility.

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