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The Federal Reserve: Ignoring market signals since 1913

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      By Eric Stein, CFA, Co-Director of Global Income, Eaton Vance Management

      Boston - While the Federal Reserve's 25 basis point rate increase and lowering of the "dot plot" were widely expected by market participants, the initial interpretation of the Fed's message was quite hawkish.

      Equities fell, the U.S. dollar rallied and the U.S. Treasury curve flattened substantially after Wednesday's Fed announcement. While the dollar on Thursday has reversed the rally, the flatness of the curve concerns me and indicates that the Fed may be making a policy mistake.

      At Eaton Vance Management, we have differing views on exactly how much the shape of the yield curve matters, but I certainly think the shape of curve is a very important market-based signal.

      Blog Image Stein Fed Curve Dec 20

      The arguments that the yield curve doesn't matter are typically based on other longer-term factors that certainly do affect the yield curve, such as U.S. Treasury market issuance policy and foreign buying of Treasurys. However, none of these other factors changed on Wednesday afternoon. What did change was the FOMC meeting release and Chairman Jay Powell's comments at his following press conference.

      At that press conference, Powell seemed almost tone deaf to me, and also seemed to be ignoring many of the more concerning market signals that have developed over the past few months. To me, the biggest issue was that he said the pace of Fed balance sheet normalization is on "autopilot."

      Many in the markets had been hoping the Fed would, at a minimum, consider slowing the pace of balance sheet normalization. Even some Fed officials have admitted recently that they don't know exactly how much in reserves the financial system will need in the new, post-financial-crisis world. There have also been acknowledgements that the Fed's balance sheet (and the subsequent amount of reserves in the system) will be larger than they had previously anticipated.

      Blog Image Inflation 10 Breakeven Dec 20

      Normally, you would expect a smaller Fed balance sheet, and thus less Fed ownership of U.S. Treasurys, to make longer-end Treasury yields go higher. Instead, Treasury yields fell and bond prices rallied on the FOMC announcement and equity markets sold off during the press conference. Why was that? Well, I think the market took the tone deaf nature of this comment on the Fed balance's sheet as a hawkish signal from the Fed. Therefore, the signaling value and liquidity impulse of the Fed's balance sheet policy were the more important takeaways.

      Bottom line: As Mike Tyson famously said, everyone has a plan until they get punched in the mouth. I think this quote is very appropriate to yesterday's Fed announcement. While the Fed appears willing to alter its plan on rate hikes in 2019 (with the dot plot coming down to two projected hikes in 2019, from three previously), the market may well force Fed officials to change their plan with regards to balance sheet policy. While the U.S. economy still appears on very strong footing today, if the Fed ignores market-based signals such as the shape of the yield curve, the widening in credit spreads and the decline in inflation-breakevens -- it is certainly doing so at its peril.