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The Fed: Trick or Treat?

Written By Briton Ryle

Posted October 30, 2014

The latest FOMC meeting came just in time for Halloween. Did it trick the markets, or treat them?

Given the Federal Reserve’s consistency throughout the year-long tapering of its QE3 monthly asset purchasing program, it definitely did not trick anyone, delivering precisely what was expected:

“The Committee decided to conclude its asset purchase program this month,” the Federal Open Market Committee’s press release stated after giving a long list of reasons why it believes the economy no longer needs the Fed’s stimulus.

No trick at all, but no treat either. In light of the recent stock market tumble since September 19th in which the major indices lost from 6% to 11% by the time they hit bottom on October 15th, rumors had been circulating that perhaps the FOMC would delay the removal of the last bit of QE3 and keep it going another month or two.

But the Fed stuck to its plan, and refused to give the stock market any more sugar candy. As a consequence, stocks fell on the release of the FOMC’s statement at 2 pm yesterday, as noted by the arrow in the graph below, with the S&P 500 index sinking as much as 12 points or 0.605% within 15 minutes.

Market reaction to Fed announcement


Yet after traders and analysts had taken some time to read through the Fed’s statement, they found that the FOMC had left some treats scattered around here and there after all. Within minutes, the market climbed right back up to its descending trendline for the day (blue). After testing the day’s low (red) by the start of the 3 o’clock hour and finding that the low had held, buyers started piling back in, lifting the S&P back up above the level it was at when the Fed’s statement was released (green).

So what treats did the market find embedded within the FOMC’s statement? And what suddenly made them so optimistic? Two things, really: a) the state of the economy, and b) the FOMC’s assurance that it will keep standing by.

Economy is Strong Enough

The Committee made it very clear that the economy is strong enough to get by without the need for continuing the Fed’s stimulus of monthly purchases of bonds and mortgage-backed securities.

“… economic activity is expanding at a moderate pace,” the statement assured in its opening sentence. “Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate,” currently at 5.9%, the lowest it has been since the economic crisis, having fallen steadily from a 2009 high of 10%.

Other signs of an improving U.S. economy noted by the Fed include:

“Household spending is rising moderately”, “business fixed investment [spending] is advancing”, and “the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.”
In a nutshell, then: people are working, shoppers are spending, businesses are investing, and inflation has picked up.

Add them all together and you get an economy that is humming along rather nicely without requiring any more stimulating monthly doses of sugar from the Fed, giving it the all-clear to go ahead with the final cut to QE3 and end it for good.

Yet after making it clear that the economy is showing signs that it is strong enough for Daddy-Fed to let go of its hand, the FOMC also made it clear that it was not abandoning the economy all together, giving traders a little shot of hope and enthusiasm which didn’t really kick-in until the end of the day.

Daddy-Fed Still Close By

After citing examples of economic improvements, the FOMC next explained that it still remains concerned.

“…the recovery in the housing sector remains slow,” it stressed. We must remember that the re-inflating of housing prices after they had imploded from 2006-09 was one of the Federal Reserve’s chief motivations for lowering interest rates to near zero and keeping them there for more than 5.5 years so far, since lower rates make home buying more affordable, lifting demand, and home prices with it.

Another reason why the Fed lowered interest rates was to stoke inflation, since lower interest rates weaken the dollar, which in turn makes goods and services more expensive, driving up inflation which contributes to reinflating not just the value of homes but also of companies and their stocks – which had also been pummelled during the crisis.

Despite notable strength in the economy, the Fed is not satisfied with inflation where it is; it’s still too weak. “… inflation in the near term will likely be held down by lower energy prices and other factors,” the statement explains.

Hence, because the housing recovery has recently turned flat, and because inflation is being held down by falling energy prices and “other factors” (including slower growth in Europe and Asia which has strengthened the value of the U.S. dollar, slowing the inflating of prices in America) – the Fed has decided to still keep interest rates at their all-time historical lows until housing recovers again, the USD weakens again, and inflation rises again.

“… the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds [interest] rate remains appropriate,” their statement revealed. “The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

That was yet another treat, the reiteration of the most intoxicating of all FOMC expressions: “for a considerable time”. Even though the Fed is letting go of QE stimulus, it will still be keeping interest rates down “for a considerable time” – especially if inflation continues to run below the Fed’s 2% annual target, and the future expectation of inflation remains “anchored”, or stuck. The Fed wants growth via inflation, and it is prepared to keep interest rates low as long as it has to to get it.

Investors Have a Green Light

So what does all of this mean for investors? Simply put, the economy is improving strongly enough to end Quantitative Easing, but not strongly enough to warrant raising interest rates just yet.

If you have been around stocks the past five years you’ll know that the markets love low interest rates, as they reduce the cost of borrowing, allowing companies to expand, generate more revenue, and cut their operating costs. Well, now the markets know they can keep counting on these low rates for a while longer, meaning stocks will continue to rise for a while longer.

But how much longer? Just when is the Fed going to raise interest rates? Will it be as early as Q2 of next year as many believe? Or the beginning of 2016 as others suspect?

This the wizards of monetary policy have not revealed. In fact, they have remained as ambiguous as they possibly could:

“If incoming information indicates faster progress toward the Committee’s employment and inflation objectives… then increases in the target range for the federal funds [interest] rate are likely to occur sooner than currently anticipated,” the statement covers the “maybe-sooner” side.

“Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated,” the statement covers the “maybe-later” option.

All we know is that sooner or later interest rates will rise, with the Fed remaining flexible to bend either way as “incoming information” dictates. They’re playing it by ear.

Investors, however, shouldn’t be overly preoccupied with the rising of interest rates, since as we have already covered here, the Fed is deeply committed to ensuring the economy grows, the unemployed have work, and inflation expectations remain solid at 2% per year.

The Fed will not do anything to jeopardize that stability, meaning that the equity markets will not be jeopardized either. They may correct a bit on that first rate hike, perhaps some 10% like we just experienced on the anticipation of the end of QE. But once the event passes, so will the fear.

QE is now gone and the markets are still within 10% of their all-time highs. The band-aide was ripped off with maybe just a little flinch. But the markets are healthy and strong, and Daddy-Fed is still right there to catch Little-Equity should he ever stumble and scrape his knee again. Investors have a green light to run.

Joseph Cafariello