Fed Minutes Drive Whipsaws

What happened in the two hours following the release of the January Federal Reserve meeting minutes?  A 1.8% fall in equity indices, accompanied by a rapid jump in bond yields and a broad recovery in the US dollar. The Dow Jones Industrials Average made a 430-pt turnaround in 90 minutes (from 266 pts intraday rally to closing 166 pts in the red). So why did the Fed Minutes Drive Whipsaws?

 

So what happened?

Within the first 20 minutes of the release of the FOMC Minutes, the US dollar fell across the board, while stocks indices rallied to their session highs on the relief that the Fed would not necessarily accelerate the pace of its monetary policy tightening, and would stick to 3 interest rate hikes in 2018, 4 at best.

The above explanation reflects the release of the minutes, which contained further evidence of a broader consensus among Fed members that inflation will continue to rise gradually, but no clear consensus with regards to the extent of the policy response. Further rate increases do not necessary imply faster rate hikes.

 

After 14:30 Eastern Time

So why did bond yields rise sharply later on, lifting the US dollar and dragging down indices? Here are a few possible explanations:

• Traders may have realized the minutes were somewhat outdated. In the 3 weeks since the January meeting, bond yields rallied on the combination of potentially inflationary dynamics (CPI, hourly earnings) and bond-negative developments (more deficit spending from the White House and plenty more issuance of government bonds raising bond supply).
• Mixed evidence of tightening labour markets could bolster the case for delivering less tightening than is expected/preferred by the “bond market vigilantes”, which leads to the market to do the tightening for the Fed.
• As a result, the Fed Funds futures (not the Fed forecasts) shifted to pricing as much as 74 basis points in the next 12 months, the most aggressive jump since May 2010.

 

 

Yields await Powell Testimoney

In summary, Wednesday’s volatile price movement was a confirmation that equity indices and overall risk appetite are not yet ready for 3.0% yields in the US 10-year bond. The subject will be rigorously revisited at next week’s Congressional testimony by Fed chairman Jerome Powell, whose support for Trump’s reckless budget will be highly scrutinized by the bond market, especially if he keeps the door open for 4 rate hikes.  The combination of late-cycle rate hikes with a damaged volatility curve stands to deliver more fireworks ahead.