Move Over Wonder Woman; Yellen Speaks

by Timothy D. Carkin, CAIA, CMT
Senior Vice President

The broad markets performed as expected this week as the Federal Reserve announced its much expected rate hike Wednesday. The Dow Jones Industrial Average did set a new high after the announcement but finishes the week up only 0.4 percent. The broader S&P 500 is down 0.2 percent while the tech-and-healthcare-heavy NASDAQ fell more than 1 percent. Contrasting the rather tame market returns this week was the continued shakeup in sector leadership with financial stocks winning the week up 2.4 percent, as they benefited greatly from the exodus from the technology sector, which was down 3.2 percent. The bond market showed its resilience with the 10-year Treasury registering a 2.11 yield after the rate decision, the lowest level seen since November. Interestingly, investors chose this week to move money into stocks at a rate we haven’t seen but once before: December 2014. According to EPFR Global, exchange-traded funds took in more than $30 billion dollars.

All Eyes on Inflation

For the third time in six months, the Federal Open Market Committee raised the overnight lending rate 0.25 percent, to a target range of 1.0 – 1.25. This was a foregone conclusion in most investors’ minds as they turned to the “dot plot” and commentary to glean insight into future moves. The dot plot did not change, still leaving room for one more hike this year. The market is less certain, however, lowering odds of another rate hike to 40 percent.

The biggest changes came in an addendum to the meeting minutes where the Fed outlined plans to normalize its balance sheet. The plan is to allow the balance sheet to shrink by $10 billion a month and increase that level quarterly until that number is $50 billion. This is a relatively aggressive departure from their current process which was once described by Philadelphia Fed President Patrick Harker as “like watching paint dry.” It is good to see the Fed focused on reducing and normalizing their balance sheet but inflation could be a stumbling point.

Speaking of inflation, it is worth noting that the Fed changed its characterization of inflation. “Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.” Recent reading in both headline and core CPI show deceleration, again, moving away from the Fed’s targets. Yellen later commented, "We continue to feel that with a strong labor market and with a labor market that’s continuing to strengthen, the conditions are in place for inflation to move up." In economic circles this is referred to as the Phillips curve, which posits an inverse relationship between inflation and the unemployment rate. Yellen is betting that strength in the labor market and continued economic growth will move inflation up to the target rate. The below chart is the Fed’s five-year breakeven inflation rate; the risk is that inflation continues to defy the Fed which could seriously hinder their plans for future rate hikes.

Source: Bloomberg

Source: Bloomberg

Our Takeaways for the Week

  • Odds of another Fed rate hike this year are 40 percent

  • Inflation needs to play ball if we are to keep to Fed's schedule