What The Market Chose To Ignore In Yesterday's Fed Announceent

Yesterday, in a carbon-copy response to what happened in December 2013 when the Fed announced the Tapering of QE, stocks first sold off then, as if to validate the Fed's decision as being accurate, saw a dramatic buying surge which pushed them to close just off the highs. With bonds and gold selling off while the dollar rebounded, the Fed could not have asked for - or engineered - a better reaction, while markets, as Bloomberg's Richard Breslow points out, 'chose to hear the parts of the statement and press conference that they wanted to."

That was the easy part. The hard part now is how to ween the market away from the old narrative, the one which has pushed the S&P to record highs over the past 7 years on bad economic news, and to renormalize the market's own "reaction function" to that of the Fed. The problem is that from day one there is a major discrepancy between the two: as previously observed, the Fed did not deliver the desired dovish hike, and kept its 2016 year-end fed funds rate unchanged at 1.4% suggesting 4 rate hikes in the coming year, and which as Breslow notes means "being less dovish than the meeting previews suggested is now a sign of bullishness on the economy." This sets the Fed on a collision course with the market because "with the market pricing fewer hikes than the Fed suggests, someone is going to end up being wrong. If we do get four hikes next year, markets (read equities) will need to deal with a hawkish surprise. If the Fed is forced to backtrack, there goes the full-speed ahead theme."

What this explicitly means is two things: bad economic news is no longer good for the market - after all the dominant paradigm now is one of strong dollar=strong economy=strong S&P (ignoring that the stronger the dollar, the worse the earnings recession sets up to be, the sharper the full economic recession), and that as Breslow concludes, the "Fed needs to focus on the real economy and get out of the QE mindset. I suspect that will be easier said than done."

Finally, what yesterday's hike also ignores is that as Jeffrey Gundlach explained recently, the economy is at a worse place than where it was the last time the Fed could have hiked, the industrial recession is now official, the earnings drop of the S&P500 is far more steep than it was 3 months ago, and China's renewed devaluation is signaling that it is all uphill from here from the emerging markets.

Yes, the markets did not "freak out" yesterday (and they seem rather stable today), but once the post-rate hike "signaling" rush and euphoria wears off, the only answer is that the Fed did, as DB and BofA's Michael Hartnett suggest (more on that shortly) a policy error and even the "markets", having largely lost their discounting ability, will sooner or later reach that conclusion.

Here is the full comment by Bloomberg's Richard Breslow:

Time for Plain Speak

Most of the initial post-FOMC conclusions (stress on the word initial) have focused on the positive market reaction. The S&P, after all, ended the day with big gains and other markets didn’t freak. That’s not a bad thing. The hope seems to be that it will be sufficient to see us through year end and then we’ll see what the new year brings. Asset markets chose to hear the parts of the statement and press conference that they wanted to.

Being less dovish than the meeting previews suggested is now a sign of bullishness on the economy. The dot plot having significantly more tightening than market pricing is okay because the word “gradual” seemed to work its way into each sentence. It really does feel like Chair Yellen worked her magic, because the misdirection was masterful

Beyond December, for the Fed to have pulled this off successfully, they will need to change the reaction function of the market to news - a response mechanism that has been codified and ossified for seven years. That will be the much harder task.

The dollar will have to be allowed to rise without Fed speakers channeling their inner Chamber of Commerce. Policy divergence should be sold as a sign of the U.S. functioning, finally, as the global growth engine.

To make the “I’m feeling good about the economy” message something more than a throw-away line, they need to kill the bad-news-is-good sickness. This will entail being a lot more straightforward about what gradual and data-dependent mean. Gradual to the market means how many rate hikes in 2016. To a room full of economists it means reaching a forecasted neutral rate three years from now.

This is really important because with the market pricing fewer hikes than the Fed suggests, someone is going to end up being wrong. If we do get four hikes next year, markets (read equities) will need to deal with a hawkish surprise. If the Fed is forced to backtrack, there goes the full-speed ahead theme.

The Fed needs to focus on the real economy and get out of the QE mindset. I suspect that will be easier said than done and those balance sheet reinvestments won’t be going away anytime soon