The Fed, German Elections and Tax Reform – Markets Take the Latest News in Stride

As expected, the Federal Reserve announced the commencement of its balance sheet runoff at last week’s meeting. The meeting did, however, contain a few surprises. First, the Fed maintained its expectation of another rate hike in December. Prior to the meeting, the odds of a rate hike in December were 53 percent, according to Bloomberg’s world interest rate probability, as investors weighed the Fed’s previously stated intention of a hike in December against persistently low inflation readings. Following the meeting, however, those odds spiked to 64 percent.

The Fed also upgraded its forecast of economic growth for the full year from 2.2 percent at its June meeting to 2.4 percent, implying a rather healthy 2.7 percent pace of growth in the second half. And despite maintaining its outlook for another rate hike in December, the Fed lowered its full-year core inflation forecast from 1.7 percent in June to 1.5 percent. In the post meeting press conference, Chair Yellen reiterated her view that some of the recent downward pressure on inflation was attributable to transitory influences and was likely to eventually move higher.

In addition, the Fed kept in place its expectation for three additional quarter-point rate hikes next year, but reduced its outlook for 2019 to include just two more hikes, not three. This came despite the Fed slightly upgrading its forecast for growth in 2019 and leaving its inflation outlook unchanged. The longer-run rate forecast for the fed funds rate was also reduced from 3.0 percent to 2.8 percent.

The market response to the increased odds of a December rate hike was swift. Bond yields rose across the yield curve. Following the Fed’s decision, the ten-year treasury note jumped four basis points to 2.28 percent, and the two-year made a similar move to 1.44 percent. This change comes on top of a move higher that began two weeks ago when the ten-year yield was 2.04 percent and the two-year was 1.27. The dollar also firmed on the Fed decision, and gold moved lower, continuing their own two week trends. Stocks moved slightly lower after the Fed, and ended the week with a modest loss. The S&P 500 fell just 0.1 percent. But last week’s better performers were the same as in the prior week. Financial stocks rose 2.3 percent on the week and are higher by 6.4 percent in the past two weeks. Industrials and materials both climbed 2.0 percent, adding to their recent gains (as measured by the S&P 500). …read more

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