Fed Doves Rally Bulls
By Liz Rappaport
3/21/2007 4:37 PM EDT
Traders saw only doves Wednesday, despite the hawk, or perhaps the vultures, circling high above.
The Federal Reserve kept the fed funds rate steady at 5.25%, as expected, but changed the language in the accompanying statement to soften its tightening bias. Traders read the statement as solidly dovish and indicative of a near-term rate cut, even though the Fed also took pains to emphasize that inflation is the key risk
to its outlook.
The stock and bond market rallied immediately after the statement was released. Stock traders shrugged off earlier concerns about FedEx's (FDX) earnings and comments about an uncertain economy, sending major averages on their sharpest rally this year.
The Dow Jones Industrial Average jumped 160 points, or 1.3%, to close at 12,447.52. The S&P 500 gained 1.7% to close at 1435.04, and the Nasdaq Composite gained 48 points, or 2%, to close at 2455.92. FedEx ended the day down 1.2%.
The bond market likewise rallied. The 10-year Treasury bond rose 4/32 to yield 4.53%. The dollar weakened on the Fed's statement, and gold was up slightly.
While longer-duration Treasury bonds did not rally so dramatically, shorter duration bonds rallied more sharply, indicating traders' belief that the fed funds rate will soon be lower. The 2-year Treasury's yield dropped nine basis points to 4.52% -- and is no longer inverted to the 10-year's yield.
Ultimately, the Fed covered its proverbial rear end with this statement. The central bank gave itself the wiggle room to cut rates if need be -- to respond to some kind of financial crisis or fallout from the subprime mortgage market's current malaise. But it reasserted concerns about inflation, enough to maintain its credibility and to let markets know that a cut is not imminent.
"Traders may start to lean toward believing June could be the first rate cut, as opposed to August, but the market won't really start to believe that until there is more data to support it," says Marc Pado, chief market analyst at Cantor Fitzgerald. The fed funds futures market prices in a 40% chance of a cut in June, up from 24% odds prior to the FOMC statement. For August, the market now puts 85% odds of a rate cut, up from 65% before 2:00 p.m., according to Miller Tabak.
In the first part of the statement, the Fed "marked to market" its assessment of growth and inflation, as Lehman Brothers' chief economist Ethan Harris put it. On the growth side of the equation, the Fed moderated its optimism. The Fed replaced "somewhat firmer economic growth" and "stabilization" in the housing market with: "Recent indicators have been mixed and the adjustment in the housing sector is ongoing."
The central bank also tempered the inflation paragraph, which reads: "Recent readings on core inflation have been somewhat elevated." That's opposed to January's statement, which read: "Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time."
The key changes came at the end of the statement. The Fed changed its boilerplate language, dropping the notion of further rate hikes. The new language reads: "Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." (Italics added.)
The old language reads: "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." (Italics added.)
"The Fed is not eliminating their tightening bias, but they are softening it up a bit," says Harris. "It's the way you react to broader uncertainty. You want more flexibility."
Today's statement suggests a Fed that is "trying to figure out if there will be a second dip down in the housing market," Harris says. "It is difficult to assess ... the scale and economic impact of the subprime sector's problems."
The financial sector rallied sharply on the FOMC statement and on the heels of a strong Morgan Stanley (MS) earnings report. Morgan Stanley rose 7%. Goldman Sachs (GS) and Citigroup (C) both gained about 3%.
In addition to financials, major averages were led by strength in technology stocks following better-than-expected earnings late Tuesday from Oracle (ORCL) and Adobe Systems (ADBE).
Fed Doubles Down
Despite Wednesday's market fireworks, many economic data points have been somewhat weaker since the last FOMC meeting on Jan. 31. Income and labor market measures remain firm, but that strength is not feeding into solid retail sales, and regional manufacturing reports have been dim. On inflation, unit labor costs are at a six-year high, and producer prices jumped sharply, adding pricing pressure into the pipeline for consumer goods.
"We can't discount inflation," says Joe Brusuelas, chief economist at IDEAglobal. "The Fed doubled down."
As the market rallied, some traders stepped back from the excitement to question the context of the FOMC statement and whether it really is "bullish" or not. It is possible that others might wake up Thursday and do the same.
"The Fed believes the economy is slowing and inflation remains sticky -- is that not stagflation?" writes Randy Diamond, trader at Miller Tabak. "We rally on this?"
Yep. We did. Rate cuts in this environment of fear and anxiety seem a bit like catnip: tasty, but not necessarily healthy.