Can Janet Yellen hit the market's sweet spot?
The day has finally come: On Wednesday, the Federal Reserve is expected to end its historic experiment with near-zero interest rates that it started in 2008.
This would be the first rate hike in nearly a decade, would represent the latest start of a monetary tightening campaign during an economic expansion and come as the recovery has already run longer than 29 of the last 33 rebounds. Financial markets, which have grown increasingly dependent on the flow of cheap dollar funding from the Fed (as well as multiple bond-buying stimulus programs), are understandably on edge.
Can Fed Chair Janet Yellen deliver the "dovish hike" Wall Street is looking for?
Recent volatility in corporate bonds (both high-yield and investment-grade issues), currencies, commodities and equities reveals the stakes in play. The Dow Jones industrials index is perilously perched just below its 50-day and 200-day moving average and has set a disturbing pattern of lower highs and lower lows since peaking in May.
Equities overall have been plagued by waning breadth as buyers focus on a narrowing list of stocks (such as Microsoft (MSFT)) to hold the major indexes aloft. This is a sign of vulnerability and slack buying demand. That's understandable, given the slowdown in recent economic measures (such as U.S. manufacturing activity) and corporate earnings growth (expected to drop for the third consecutive quarter in this year's last period, a downtrend not seen since the financial crisis).
Bonds have been hit by fund freezes, redemption requests and disorderly market moves as fearful selling hits illiquid markets. The recent spread of bond market weakness to investment-grade issues garnered some attention from Goldman Sachs, which noted that the slump in investment-grade bonds relative to equities (which have outperformed by 4 percent over the past two weeks) bears monitoring because it suggests stocks have some downside risk.
With the stage that crowded with actors, it's an understatement to say Wednesday will be busy in the markets.
According to Bank of America Merrill Lynch's Michael Hanson, with a rate hike all but certain, investors' focus will be on whether the Fed can deliver a gentle move that combines the start of a tightening campaign with a promise to be very gradual regarding the pace of any subsequent hikes.
Currently, the futures market is looking for just 1.8 hikes in 2016, while Hanson expects the Fed's latest "dot plot" summary of individual forecasts to show four rate hikes next year -- which is only half of the average pace of the prior several rate hike cycles.
It will be tough for Yellen to hit the market's dovish expectations while maintaining a commitment to data dependency amid a steady pace of job gains and a stabilization in inflation measures. Indeed, on Tuesday the November CPI report came in largely as expected, rising at a 0.5 percent annual rate, while the core rate (excluding food and energy) is rising at a 2 percent annual rate.
As the chart above above shows, price pressures are clearly building. And as shown below, there's a big gap between prior tightening paces, the Fed's expectations (median dot) and where market expectations are.
As a result, Hanson believes it's likely investors will be disappointed with Wednesday's outcome and is looking for the U.S. dollar to actually weaken, possibly pressuring a crowded long-dollar trade and putting a damper on financial markets overall.
Of course, it's always possible that the Fed holds off -- as it did back in September after stock market losses raised concerns -- and pushes another dose of its monetary adrenaline into the veins of the financial system.
