The Strike Price on the Powell Put is a Lot Lower Than the Market Thought, But…December 19, 2018
The Federal Reserve today announced a .25% hike in the fed funds rate today, as highly anticipated. What was not anticipated was the hawkish tone projected by the Fed in its statement as well as by Chairman Jerome Powell in the press conference, at least relative to market expectations. This relatively hawkish tone forced stocks to make new lows on the year, but also open up (ever so slightly) the possibility of some valuation support provided by the Fed for the first time in more than a year. Before we continue, let’s give some background information for what was known and anticipated prior to today.
- Going into today’s meeting the Fed had projected three interest rate increases for 2019.
- The financial markets never fully anticipated the Fed would hike three times in 2019, but just last month the market anticipated a 66% probability of at least two hikes and a 31% chance of three or more hikes in 2019.
- Over the last month, the market’s expectations for Fed hikes changed quite a lot as equity markets sold off. Going into today, the market had priced in only a 34% chance of least one 2019 hike and just a 7% chance of two or more hikes. Effectively, over the last month the market removed a bit more than two full interest rate hikes from its 2019 forecast.
- It was therefore anticipated that the Fed would also bring down its projection for year-end 2019 Fed Funds by about .5%, or the equivalent of two interest rate hikes.
Given these market derived expectations, it was a surprise to investors generally when the Fed’s statement and “dot plot” suggested the Fed would hike rates twice in 2019. In other words, the Fed only removed one rate hike from it’s 2019 projection when the market was expecting two hikes to be removed. Fair enough, but it didn’t end there.
Enter Chairman Jerome Powell. Chairman Powell made at least four separate statements during the press conference that market participants interpreted as hawkish.
- He began his press conference by responding to a question about where the neutral Fed Funds rate – the rate at which policy is neither restrictive nor accommodative – resides. He responded by saying that after today’s hike, Fed Funds will be at the lower end of the neutral range, and will be in the middle of the neutral range after two more interest rate hikes. In other words, the Fed Funds rate will not be where he wants it until they hike twice more.
- Powell later reinforced this statement by saying, “policy is not currently restrictive”.
- He said that the committee was not currently discussing making changes to its policy of balance sheet shrinkage and he did not anticipate the balance sheet policy would change. Said differently, the Fed will keep tightening monetary policy via balance sheet shrinkage for the foreseeable future.
- Possibly most importantly, Chairman Powell stated in no uncertain terms that Fed policy would only be altered on the count of financial market turbulence if there were to be material changes in broad financial conditions that are sustained for a long period of time. In other words, the 13% peak to trough selloff in US stocks since September (before today), does not quality as either “material” or “sustained”.
That was a doozy, and made clear to market participants that policy relief that could make a real difference to financial markets in the near term – all out rate cuts and stopping the balance sheet runoff – are a long way off. In essence, the Powell Put is not close to its strike price. In response, stocks sold off, bond yields ratcheted lower, the yield curve flattened, and the US dollar rose (charts below).
Now, despite all the tough talk from the Fed today, there is one bright spot in all this. The Fed’s terminal rate – the rate at which they think Fed Funds will eventually settle, was also reduced by .25%. This matters because 1) it was reduced for the first time in more than a year (red line in the chart below) and 2) there is a high correlation between the Fed’s terminal rate and the the P/E ratio of the S&P 500 (blue line in the chart below). This slight change in policy may take a bit of pressure off equity valuations, which have fallen by fully 25% this year, and that would certainly be welcome news to equity investors.