Neutral Fed Confounds Investors

The Fed ended its meeting yesterday and announced that they were leaving the Fed Funds rate where it is. They also stated that they would be patient before making the next move without giving any indication whether the next move would be a cut or a hike. Personally, that is exactly what I expected from this meeting. And it’s what I expect at the next meeting.

What I didn’t understand was why investors reacted like the Fed’s announcement was a big surprise. It seemed to confuse investors and we saw odd reactions to different asset classes. Stocks dropped, the dollar jumped—which led to gold falling.

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Look at the intraday charts for these ETFs that represent the dollar and gold. The blue arrows represent the time of the Fed announcement.

Were investors expecting the Fed to make a rate cut or state that they were leaning toward cutting? President Trump seems to be the only person that thinks the Fed needs to cut rates right now, and I think that is a short-sighted view. Sure I would love to see rates go down for personal reasons, but from an overall economic perspective, cutting rates right now would be a huge mistake in my view. If you cut rates now while the economy is growing at a nice pace, you will have fewer actions you can take in the future when the economy is weakening.

It has been a long time since we had a neutral Fed. It seems like the Fed has been either hawkish or dovish for the last 20 years. Rates were rising in the late 90s as the stock market was going strong and the economy was rolling along. The bear market hit in 2000 and the Fed seemed to shift directly to a dovish stance and skipped the neutral phase.

The Fed funds rate stayed at 1% for an extended period in 2003 and 2004 as the bear market ended and another bullish phase started and the Fed turned hawkish and raised rates from early 2004 through mid-2006. If there has been a time in the last 20 years when the Fed was neutral, I would say it was from mid-2006 through the third quarter of 2007. Then the financial crisis hit and the Fed jumped to a dovish stance and cut rates all the way to 0.25%.

The Fed kept the target rate at 0.25% from December 2008 until December 2015. One could argue that the Fed was neutral during this phase, but with a rate of 0.25% and numerous quantitative easing programs going on besides making rate adjustments, the Fed was dovish that entire time in my eyes.

I have stated before on Bull Market Rodeo, or at least I think I have, I think the Fed made a mistake in keeping the target rate at 0.25% for so long while the economy was expanding and the stock market was climbing. From the bear market low in March 2009 through March 2012, the S&P doubled. By the time the Fed bumped the target rate up to a range of 0.25-0.5%, the S&P had tripled from its 2009 low.

Don’t get me wrong, the stock market isn’t the only gauge of how the economy is doing, but it is one measure. Unemployment peaked at 10% back in late 2009, but then it started falling gradually. I mentioned that the S&P doubled by March 2012. Later in 2012 unemployment had dipped below 8%. That’s a little higher than we want, but it was moving in the right direction and the Fed had not moved. By the time the Fed did act and make its first hike in January 2016, unemployment was under 5%.

Here we are today with the S&P at an all-time high, the unemployment rate is at 3.8%, and the Fed Funds rate is only at 2.5%. From a historical perspective, the current rate is still below average. What do investors want the Fed to do? President Trump wants a cut for his own reasons. I personally think if the next move by the Fed is a cut it will be a bad sign for the economy. I don’t see the Fed cutting just to appease the President and I think he would be better off not telling the Fed Chairman to cut rates. As long as the economy is rolling like it is, Chairman Powell will likely take the President’s remarks more as a challenge than a suggestion. In order to maintain the perceived independence of the Fed, the more President Trump calls for a rate cut while the economy is strong, the more the Fed is likely to hold rates where they are.

Why Wednesday’s announcement confounded investors is beyond me. The reactions from different asset classes suggest that the majority of investors were expecting a different outcome.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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