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Who will blink first — Fed or the market?

Published: May 26, 2016 6:18 a.m.
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Market is surprisingly gaining despite higher chance of summer rate hike

The S&P 500 on Wednesday finished within a hair’s breadth of its 2016 record close set in April, when investors weren’t pricing in any Fed rate hikes until December.

Back in April, federal-funds futures were pricing in a less than 10% probability of a rate hike in June.

The Federal Reserve, concerned that the market is too complacent about the future path of rate increases, put everyone on notice last week. Several Fed officials said that a June rate hike is likely if economic data warrant it, while minutes from the latest policy meeting revealed that many policy makers would like to raise rates in June if conditions continue to improve.

Yet, the reaction in the market has been near euphoric. What changed?

There are two possibilities: Either the market doesn’t believe the Fed or the market believes the Fed thinks a rate hike — a sign that the economy is improving — supports higher prices for stocks.

“Right now it looks like the market is saying that it can digest another 25-basis-point rate hike, that a rate hike is a sign the economy is stronger. Maybe the good news is good news,” said Joe Saluzzi, co-head of Equity Trading at Themis Trading.

Saluzzi argues that the market should not be able to dictate Fed policy, but pointed out that historically the central bank has been too sensitive to the market’s reaction.

“The Fed will react if things got ugly, for example if we see big opening gaps, when stocks drop sharply at the open. But I also don’t think they will hike in June just because there are geopolitical risk such as Brexit. And they would be right to wait until July,” Saluzzi said.

But would another 10% or more drop in the S&P 500 change the Fed’s mind about hiking this summer?

Before the next policy meeting on June 14-15, either the markets will uphold the current status quo and allow the Fed to administer another 25-basis-point rate hike, or there will be another correction that will essentially do the Fed’s tightening job for it.

That’s precisely what happened in the first quarter of the year, shortly after the first rate hike in a decade. The stock market fell 14% in what would be the worst start to the year on record for U.S. equity markets. Credit spreads widened, which meant that it became more costly for businesses to borrow. Meanwhile, economic data disappointed investors, with many fearing an outright recession was looming.

Read: Fed’s Yellen may send interest-rate message by not making one

After the Fed held interest rates unchanged at its February meeting, the stock market staged a sharp recovery. The fact that the Fed decided to take a step back from the tightening cycle earlier this year and waited for data and market conditions to improve was perceived by many market watchers as though the central bank’s sole purpose is to prop up asset prices. But that view is simplistic and wrong, according to George Pearkes, macro strategist at Bespoke Investment Group.

“Of course, the Fed deeply cares about financial markets because it is part of its overall model. When the dollar rises and credit spreads widen and stock markets fall — the market is doing the Fed’s job of tightening for it. So, the Fed’s response will be suspending rate hikes until conditions improve,” Pearkes said.

Opinion: Five reasons the market is ignoring the Fed about rate hikes

“It looks like the market is giving the Fed an open invitation to raise rates in June. But we know from history that the Fed can shift their stance, if there is a big correction. For example, after the last correction in January-February they went from projecting four rate hikes to two rate hikes this year,” said Jack Ablin, chief investment officer at BMO Private Bank.

As markets are trying to guess whether the Fed will or won’t raise interest rates this summer, the Fed is closely monitoring what investors collectively think of future economic growth.

While the catalyst for another correction on Wall Street may have nothing to do with monetary policy, any tightening of financial conditions, like higher borrowing costs, is likely to affect the Fed’s decisions.

http://www.marketwatch.com/story/who-will-blink-first-fed-or-the-market-2016-05-25?siteid=rss&rss=1