You can’t always get what you want

You can’t always get what you want, but sometimes you do.  Like this week.

The Fed knew exactly what to say to give the financial markets what they wanted at the January meeting.  Previously, the official communication from the Fed at the December rate decision left investors in a panic of a policy mistake.  Chairman Powell’s word choice on shrinking the Fed balance sheet brought the word “autopilot” to the media and the minds of traders.  Equity markets crashed as the average forecast for the Fed Funds trajectory showed continuous hiking throughout 2019.  The Treasury curve developed a funny little bump on the short-end.  Specifically, the rate on the 1-year Treasury raised up over the 3-month T-bill, but then fell in the 2-year Treasury and remained lower all the way out to the 6-year maturity.  The Fed is a closer follower of the financial markets than they care to admit because almost immediately they started talking back the communication gaffe.

As they did, the little bump at the front of the Treasury curve got shallower and shallower.  In fact, we suggest that most of the equity rally in the last days of December through January was driven by the dovish tone of the Fed until reaching the crowning moment on Wednesday January 30th when we received confirmation…….the “pause.”  In addition, we had a re-casting of the role of the balance sheet roll-off.  It is now a complement to the primary tool of the Fed Funds rate and not intended to be a signal of policy intention.  All of that is to say that the Fed is adjusting expectations so that the balance sheet of the central bank will remain large for some time to come.

Of course, the market has rejoiced in the Fed returning to its “data-dependent” mantra and away from that scary “autopilot” of tightening. Why not?  After wondering whether there was a Powell “put” for equities (as there has been for his predecessors), the communication suggests it is still in place.  But as the market tends to do, the pendulum can swing from too-scared to too-fearless.

Looking at Fed Funds futures through the rest of the meetings of 2019, it is now implied by the market that the Fed will not only stay on pause, but is more likely to cut later in the year.  In fact, by December, there is an almost 30% chance of a cut priced in with a 0% chance of a rate hike.  You would think a data-dependent route would have the odds more balanced, especially if global policy makers kick into fiscal-stimulus overdrive.  We tend to think US economic growth, while slower, will still occur and thus we should see the odds shift again…and the markets along with it.