When Romeo impatiently hankered after Juliet, the sage friar Lawrence dispensed some valuable advice: “Wisely and slow; they stumble that run fast.” It is a dictum the Federal Reserve clearly intends to live by, despite the improving economic outlook.
There have been rising murmurs in financial markets that after years of the Fed being too optimistic on the economy, inflation and interest rates, it is now behind the curve. But on Wednesday the US central bank sent a clear message to markets that it is not in a hurry to tighten monetary policy.
The Fed did deliver another quarter-point interest rate increase, only the third in the cycle that started in December 2015. Yet investors who had begun to position themselves for a faster pace of rate increases were wrongfooted by officials electing to leave most of their headline projections in place.
“It comes off as very dovish,” said John Brady, managing director at RJ O’Brien, a brokerage. “This is going to be a friendly, docile, dovish hiking cycle. At least in the here and now.”
As the dust settled on Thursday, the 10-year Treasury note yield was trading around 2.53 per cent and remained below this week’s peak of 2.63 per cent. The policy-sensitive two-year Treasury has also eased back to around 1.34 per cent, reflecting market relief that Fed officials at this juncture do not see a need to accelerate the pace of tightening.
“Positioning was clearly short,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.
Highlighting how some investors were wrongfooted, Prattle, a data company popular with hedge funds that uses algorithms to score central bank speeches and statements as hawkish or dovish, graded the Fed announcement as “neutral” despite its models predicting tougher language.
“It is obvious by the move and the language that the [Fed] feels that it is in control and its monetary policy is correct,” said Kevin Giddis, head of fixed income at Raymond James, who felt the caution was appropriate. “Say what you want, there are many geopolitical uncertainties out there to deal with, along with a free-falling price of oil and very uncharted waters on the political front.”
The delivery of a “dovish rise” — the rate increase tempered by unchanged projections for two further quarter-point increases this year — also helped boost the US equity market.
The shift in the Fed funds futures market, which has been more sceptical of an aggressive central bank, was less dramatic. The implied odds on another two rate increases this year dipped from 60 per cent to 51 per cent, and the chances of three more slipped from 24 per cent to 18 per cent.
A still-cautious, unhurried Fed has eased concerns of a re-run of “Three Steps and a Stumble”, a Wall Street adage based on the tendency of the stock market to be tripped up by the third interest rate increase in a raising cycle. JJ Kinahan, chief market strategist at TD Ameritrade, said investors have also been reassured by President Donald Trump’s plans to slash corporate taxes.
“We talked forever about the Fed put. Now we have a tax cut put,” he added. “There are great expectations about what this tax plan will involve. People are of the belief that a slight tightening of money will be OK because companies will get it back in the form of a little bit more up front from lower corporate taxes.”
The US mortgage bond market was also pleased by the Fed meeting. While Janet Yellen, who chairs the Fed, said board members had discussed how and when to begin trimming the central bank’s balance sheet — which holds $1.76tn of mortgage-backed securities — the lack of any details reassured investors. The biggest exchange traded fund that tracks the MBS market rallied the most in nearly four years after the Fed decision.
Walter Schmidt, head of mortgage strategy at FTN Financial says: “I think the mortgage market is reading into the lack of news about the balance sheet that another meeting has gone by until they will consider it again.”
Nonetheless, markets should avoid excessive complacency. While the headline forecasts did not change, nine out of 17 Fed officials are looking for three rises this year, up from six in December.
It is also only March, which leaves the Fed plenty of time to move more aggressively should it become appropriate. Indeed, the fact that financial conditions eased sharply on a day when the Fed raised interest rates will encourage the central bank’s more hawkish members.
“They’re in no hurry to raise rates but they’re data dependent and if the data continues to be strong then they’ll move faster,” says Frederic Mishkin, an economics professor at Columbia Business School and former member of the Fed’s board of governors.