Policy Change Coming Next Week?
In Tuesday's Wall
Street Journal, a reporter with excellent contacts at the Fed, Jon Hilsenrath,
penned the following:
Federal Reserve officials are seriously considering an important shift
in tone at their policy meeting next week: dropping an assurance that short-term
interest rates will stay near zero for a "considerable time" as they look
more confidently toward rate increases around the middle of next year.
Is The Market Really Worried About Inflation?
As noted recently,
inflation expectations are what ultimately determine interest rates. It is
difficult to believe the market is expecting widespread price increases when
crude oil is dropping like a stone. As shown in the chart below, oil has plummeted
more than 40% over the past six months.
Bond Market Seems Unconcerned
Fixed-income investors can buy bonds with an inflation-protection component
(TIP) or they can buy a standard bond (IEF). The chart below shows demand for
inflation-protected bonds has been much weaker than demand for standard bonds,
which does not look like a market concerned about a big spike in consumer prices
looking out several years.
Investment Implications - The Weight Of The Evidence
While the Fed looks at many factors when considering a shift in interest rate
policy, it is difficult to make the case that longer-term inflation expectations
are becoming problematic. In fact, our friends across the pond are concerned
about deflationary, rather than inflationary, forces. From Reuters/The
Fiscal Times:
French core inflation turned negative in November, with the first drop
in the indicator since records started in 1990 pointing to a growing risk
of deflation in the euro zone's second-largest economy.
During Wednesday's big selloff, we noted () it was possible stocks would find their footing near support.
During the early stages of Thursday's trading day, buyers did step in at
a logical level. The S&P 500 chart below is an updated version of the
one tweeted Wednesday. Before stocks can push higher, they must clear a short-term
resistance hurdle near 2055.
The Million Dollar Question
The market will be looking to see if the Fed drops the phrase "considerable
time" from their upcoming December 17 statement. Changing the language would
increase the odds of an interest rate hike coming in the next six months, something
that could spook the stock and bond markets.
The Reaction Is More Important Than The Statement
Rather than attempting to anticipate the market's reaction to next week's
Fed statement, our approach will be to remain patient and wait to see the actions
of market participants after the release of the Fed's December 17 statement.
If considerable time is dropped, will the market take the "this is bad
news because rates will be moving higher" approach or "this is good news because
the economy is gaining positive momentum" approach? Time will tell.
