The Market Is Acting Like the Fed Cut Rates Yesterday

Financial markets are telling Janet Yellen there’s more work to be done — or else.

While the Federal Reserve chair raised interest rates by 25 basis points as expected Wednesday, the outlook was less hawkish than market participants foresaw, with projections for the medium-term tightening cycle largely unchanged.

That propelled markets — judging by the strength of U.S. dollar, bond yields, credit spreads, and stock prices — to effectively deliver a rate cut to the tune of about 15 basis points, according to indexes published by Morgan Stanley and Goldman Sachs Group Inc.

“Our financial conditions index eased by an estimated 14 basis points on the day — about 2.3 standard deviations and the equivalent of almost one full cut in the funds rate — and is now considerably easier than in early December, despite two funds rate hikes in the meantime,’’ Goldman Chief Economist Jan Hatzius and team wrote in a note.

The S&P 500 Index’s post-Fed rally ran out of steam Thursday after the index climbed within 0.5 percent of an all-time high.

All of this leaves Yellen facing a predicament similar to one that former Fed Chairman Alan Greenspan called a conundrum in February 2005, when the central bank was raising borrowing costs and long-term yields kept falling and equity markets rallied. At the time, the dilemma was blamed on a global glut of savings.

This time around, U.S. financial conditions have loosened decisively since the Fed raised short-term rates in December, its first hike since the same month in 2015. That has delivered stimulus to the U.S. economy, while vexing the central bank’s tightening cycle.

Falling credit spreads, the S&P 500’s bull run and the fact the dollar has failed to maintain its post-election ascent this year all constitute stimulus — defying post-election fears that a tightening of financial conditions may offset President Donald Trump’s bid to boost growth.

The Fed is acutely aware of how exuberant financial conditions may boost consumer spending thanks to positive wealth effects. “I think the higher level of stock prices is one factor that looks like it’s likely to somewhat boost consumption spending,” Yellen said at the press conference Wednesday, adding that falling premiums for debt issued by low-rate companies is “another signal that financial conditions have become somewhat easier.”

Loose financial conditions “is a factor that affects the outlook” for the U.S. economy and interest rates, Yellen concluded.

New York Fed President Bill Dudley put the policy dilemma more bluntly in speech in 2015: “If financial conditions were not to tighten at all or only very little, then — assuming the economic outlook hadn’t changed significantly –we would likely have to move more quickly.”

As such, Goldman is more hawkish on the Fed’s policy trajectory than the market, citing the momentum of the U.S. economy — and excessively loose financial conditions.

It has brought forward its forecasts for two more rate hikes this year to June and September, from a previous projection of an increase in September followed by December. It now also sees the Fed announcing an end to the practice of reinvesting principal payments, a process known as balance-sheet normalization, in the forth quarter of the year, from a previous projection of mid-2018.

“Simply put, the Fed raises rates to tighten financial conditions,” Morgan Stanley economists led by Ellen Zentner wrote. “If financial conditions don’t tighten, there’s more work to be done.”

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