In another month, investors won’t have Federal Reserve money stimulus to juice up the market. In return, they do have one thing they might rather not see: An exit door.
Even if the U.S. central bank didn’t exactly start flashing the lights to indicate that the easy-money party is over, it at the very least indicated that it won’t go on forever. The monthly bond-buying program—quantitative easing—almost certainly will end in October, and the Fed last week gave a rough outline for how its zero interest rate policy will unwind in the years ahead.
Prior to the Fed Open Market Committee meeting, market participants had trained their gazes at two phrases within the statement: “Considerable time,” in reference to how long it would take from the end of QE to the first rate increases, and “significant underutilization of labor resources” regarding the job situation.
Both phrases stayed in the statement, easing consternation on Wall Street, which worried that the removal of either would be a hawkish policy stance.
What the FOMC also provided was a separate statement called “Policy Normalization Principles and Plans.” The document is a blueprint toward what factors will be taken into consideration as the Fed moves away from zero interest rates and back toward a normal regime.
The critical section detailing how it will determine the rate structure:
When economic conditions and the economic outlook warrant a less accommodative monetary policy, the Committee will raise its target range for the federal funds rate.
During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances.
During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate.
Fed watchers undoubtedly will spend many hours parsing their way through the language and exactly how it will accomplish policy normalization.
For investors, though, the necessary takeaway is that conditions are about to change. That takeaway, though, does not necessarily mean that the market’s rampant bull run is near a close, David Rosenberg, economist and strategist at Gluskin Sheff, said in a report for clients:
The Fed may have sounded dovish, but their forecasts point to rising rates ahead, and so the rate-sensitives should largely be avoided.
The rising likelihood of stronger-than-expected growth in the next several months means the high-priced defensive areas of the stock market will face the prospect of an outward rotation into the more cyclical segment, though the parts that are more domestic focused than foreign (given soft global growth and firm dollar) make the most sense…
No doubt equities will have an adjustment phase as the discount rate used to discount future profits moves higher over time, but bear markets don’t start until investors see the whites of the eyes of the recession, and that is still likely a few years away.”
Rosenberg’s words articulate the brightest hopes of the market: That rising rates will come behind stronger economic growth and thus won’t stymie the market.
The nightmarish flip side of that position is that the Fed is forced to raise rates to control inflation and falls behind the curve, loses the market’s faith and drives the economy into recession by staying too loose for too long.
For its part, the Fed is seeking to straddle the line between the two, keeping policy accommodative until it believes the economy is ready to take off but at least giving a nod toward those who worry that the Fed is oblivious to policy dangers.
“Details of the new exit strategy principles were fairly neutral with respect to the outlook for interest rates,” Credit Suisse analyst Dana Saporta said in a note to clients. “However, the very fact the Fed produced a new policy normalization plan lent a certain concreteness to the notion that the Fed may actually be tightening policy by this time next year.”
In the months ahead, investors will be looking for different things within the FOMC statement. The “considerable time” almost certainly will come out now that the reference point of QE’s end will no longer be relevant.
Economic forecasts, particularly the “dot plot,” a graph that charts Fed officials’ expectations of rates, will take on more importance, and nuances within the statement might become even more important.
That sets up a nervous time for investors, particularly if the economic data gets better and the pressure for getting away from crisis-era policies increases. Chair Janet Yellen has stressed that policy will be “data dependent,” but it’s not as clear as it once was which data will take precedence.
“Even though the language on the forward guidance isn’t changing, the fact that these dots are moving higher is probably going to have investors thinking about (policy tightening) at some point,” said Roger Bayston, director of Franklin Templeton’s Fixed Income Group. “It’s natural for the market to look for lines in the sand.”