Idea of the Day Fed and stocks

 Ahead of tonight’s FOMC meeting we have taken a brief look at the potential outcomes and the charts that are worth keeping an eye on as we await the Fed’s latest decision on rates.

• The Fed is expected to hike interest rates today and the market, according to the CME Fedwatch tool, is predicting a 99.6% chance of a hike.
• Expectations are for a “dovish hike”, with the Fed talking down the possibility of a hike later this year.
• The chances of a hike in September and December have fallen sharply. The market expects a 23.4% chance of a hike in September.
• The Fed needs to balance disparate economic signals as they make their decision: the low unemployment rate, the sharp drop in CPI to 1.9%, and a fresh record high in Dow Jones.
• The Fed also needs to consider political issues, such as a delay to Trump’s infrastructure spending plan, which could impact monetary policy going forward.
• A shock for the market would be if the Fed is less dovish than expected, however, we think that there is a low chance of this happening as there are growing signs of economic weakness, including weak retail sales, low inflation and wage growth, and a 3-month NFP average of 120k.
• After today’s weak CPI and retail sales data, we believe that there is a slim chance that the Fed doesn’t hike today, although this is a low probability event.
• Even if the Fed does hike rates today, we expect there to be dissenters. There could also be talk of raising the inflation threshold, which would be considered an extremely dovish move by the market.
• Don’t forget the “sell the rumour, buy the fact” outcome for financial markets. If the Fed does deliver a “dovish hike” as the market expects, then the dollar and 10-year US bond yields could actually rise, because they have fallen sharply in the run up to this meeting.
• The dollar is likely to be vulnerable to further declines if the Fed agrees to raise the inflation target, or adopts any other ultra dovish measures.
• Even if the Fed does sound dovish this evening, stocks may struggle if the FOMC sounds concerned about the US economic outlook.

Two charts to watch: how the Dow Jones may react.

1, US yield curve could spell bad news for the S&P 500

This yield spread has fallen to its lowest level since October 2016. This is a sign that the Fed is expected to scale back prospects of future rate hikes, it is also a sign that the US bond market is getting bearish on the outlook for the US economy.

A falling yield curve tends to be good news for stocks, as you can see in this chart, which shows the 2-10 bond yield spread and the Dow Jones index. However, the yield curve is close to lowest level since 2016, back then when the yield curve bottomed stocks struggled as the economic outlook deteriorated. Thus, even if the Fed is dovish later today then stocks may not rally. The Dow could be particularly at risk from a sell off after it made a record high on Tuesday.

Figure 1: 

Source: City Index with Bloomberg 

2, The Dax vs. Dow Jones index

The Dow has underperformed the German index so far this year. If we are correct in our view, and expect a dovish Fed tonight, then we would expect further Dax outperformance vs. the US index. 

Figure 2: 

Source: City Index with Bloomberg