All Eyes on the Fed this Week

By Brian Dolan, Head Market Strategist

Markets on Edge Ahead of FOMC Decision on Wednesday

The Federal Reserve’s policy-making Federal Open Market Committee (FOMC) is holding a two-day meeting this week, with a policy statement at the conclusion of the meeting on Wednesday afternoon at 2 pm EDT. Fed Chair Janet Yellen will hold a press conference following the statement, which will also be accompanied by an update of the Fed’s Summary of Economic Projections (SEP), a collection of economic forecasts by individual Fed members.

The market is not expecting any change to the Fed’s target interest rate, which has been held at 0.00-0.25% for the last six years. Instead, markets will focus on the language of the FOMC’s forward guidance about future policy moves. The expectation there is that the Fed will drop the use of ‘patient’ to describe its approach to eventually raising interest rates later this year. That would set the FOMC on course to initiate a rate increase potentially as early as its June 17 meeting. Futures markets are currently pricing in a relatively low probability of a June rate increase, and showing about a 50% likelihood of the first rate hike coming in September. Still, markets remain on edge awaiting the FOMC.

More than Just a Word

While the market is largely fixated on whether or not the Fed will drop the use of ‘patient,’ the overall tone of the FOMC statement will be the crucial driver of the market’s reaction. While much has been made of the US recovery, recent US data (apart from large gains in monthly jobs numbers) suggest there is still plenty of room for caution. Wages remain largely stagnant after inflation and consumer and business confidence has been slipping recently. The broad Labor Market Conditions Index (LMCI), based on 19 labor market indicators, has fallen in each month of this year, from 7.1 at the end of 2014 to 4.0 in February (the index has averaged 5.0 since 2010), suggesting employment remains delicate at best.

Elsewhere, weakness in Europe, China and Japan all pose risks to the global outlook, to which the US is inextricably tied. US dollar strength also poses another headwind to the US recovery, undermining US exports even further as demand from abroad remains soft. Dollar strength, which shows no sign of abating given market expectations of ongoing central bank policy divergence between the US and the rest, also undermines the Fed’s goal of price stability by suppressing inflationary pressures.

Cautious or Confident?

While the Fed may drop ‘patient’ from its guidance, I look for the Fed to retain an extremely cautious tone on the US outlook overall and stress the risks from international developments and possibly even the US dollar. The Fed’s own forecasts in the SEP are likely to be downgraded relative to prior estimates. The Fed’s language is likely to be extremely nuanced, leaving room for multiple interpretations by market participants; Yellen’s press conference will be critical to deciphering the road ahead. I think the lasting impression, however, is going to be of a Fed in no hurry to start tightening and seeking to maintain maximum flexibility, including doing nothing. If this more cautious tone is delivered, investors are likely to breathe a sigh of relief, as prospects of a June first-move are postponed yet again to September or even later. In this case, I would look for US yields to drop back below 2% in the 10 years and with a potential for stocks to bounce again. How long the relief bounce, if any, may last is a more difficult question, as it would have been predicated on a weaker assessment of the US outlook.

Should the Fed pronounce more confidently on the US outlook, and June rate hike expectations strengthen, it could spell a very difficult period for risk sentiment overall, as yields turn higher again and investors re-position for an earlier rate hike. From a longer-term investing perspective, such set-backs could be used to deploy additional US stock investments at reduced price levels, as the medium term US outlook remains mostly buoyant, certainly from a global perspective.