Bates Research - 12-19-14

Markets React to Fed Statement

Federal Reserve Chair Janet Yellen spoke this past Wednesday, outlining the FOMC's monetary outlook after its latest meeting. Much of the outlook is the same as it was at the last Fed meeting in October: labor markets continue to improve, inflation continues to run below the 2% target, and the current policy rate of 0-1/4% will be maintained.

There were some notable changes, however. In particular, the statement contained the following line: "Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy," which seems to have replaced the previous language indicating that rates would be held low for a "considerable time." The October FOMC announcement included the end of quantitative easing, though the current announcement notes that the Fed will continue to reinvest proceeds from existing Treasury and MBS positions, buying activity which will "maintain accommodative financial conditions." We've blogged before about the difficult time that the Fed will have reversing the extraordinary measures it took in the aftermath of the Credit Crisis. It now appears as though the Fed is slowly moving back towards normal monetary policy, or at least away from absolute accommodation.

The market's reactions were mixed -- prices for Treasury securities declined (sending yields up), and more so for shorter-dated Treasuries than for longer-dated ones. For example, two-year yields climbed from 0.54% to 0.62%, while ten-years rose from 2.06% to 2.14%. Volumes of Treasury securities traded also increased in the wake of the announcement to $446 billion compared to a daily average of $333 billion. In rough terms, this is largely what would be predicted -- bond prices fell in response to a potential increase in rates.

Equity markets struggled to interpret the new language as well, ultimately determining that the Fed's revised stance indicated more flexibility to tailor policy to the current economic environment, rather than embarking on a path towards tightening based solely on falling unemployment. The fact that the Fed felt the economy was strong enough to begin tightening was also encouraging to some investors. The S&P 500 finished up about 2% on the day, though it was still down about 3% since December 5th. The index nearly made up that remaining gap on Thursday, finishing up another 2.40%, and extending the so-called "Santa Claus rally" to finish the year.

Regarding rate levels, the Fed maintained its expectation that rates would begin to rise in 2015, but lowered its forecast range from 1.25-1.5% to 1-1.25% for that year. 2016 was similarly revised downward, from 2.75-3% to 2.5% flat. So while the timing of future rate increases has remained little changed, the speed at which they will climb from the current historic lows has been tempered. It would seem that the Fed wants to prepare markets for the end of easy money, but is willing to revise the pace at which it will do so, given current conditions. If they move too fast, they risk sending fragile markets into another downward spiral, but move too slow and they risk another bubble and inflation.

One only has to consider the many other perplexing challenges in capital markets to understand why the Fed might anticipate slower tightening. The price per barrel of oil has fallen by half since June, and many pundits have begun to connect the falling price of oil with stagnation in the underlying global economy as well. The instability and currency crisis brewing in Russia has created another unknown variable that market participants will have to factor in for 2015. While U.S. economic conditions have been improving, there are still enough reasons for the Fed to "be patient" with monetary policy. 

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