SEP-arated At Birth: Markets and the Fed

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SEP-arated At Birth: Markets and the Fed

Chalk up another win for the “Fed drift” – the documented market anomaly that sees US equities rally in the 3-day period around a Federal Open Market Committee meeting. Researchers at the New York Fed first documented this phenomenon in 2011. By their math, all the S&P returns from 1994 to 2011 came in this small window. Yes, all of them.

In a follow up note last year (link at the end of this section) they found that from 2011 – 2018 the “drift” only appeared during quarterly Fed Chair press conference meetings. What they did not know: was it the press conference, or the simultaneous release of the Fed’s Summary of Economic Projections (SEP) that pushed stocks higher?

Limited data on this point, since every-meeting Chair press conferences only started in 2019, but so far SEP meetings are batting 1000 in terms of positive market returns.

  • The S&P 500 rallied by 0.5% from March 19th to the 21st (the first SEP of the year).
  • From the open yesterday to today’s close, the S&P is +0.70%. We have one more day in the “drift” sequence, but so far so good.
  • That combined gain is 1.2%, or just 7% of the market’s gain for the year. A far cry, in other words, from the 1994 – 2011 experience when Fed days represented all the market’s gains.

To us that means that markets have gotten better at predicting what will be in the SEP, so let’s take a quick look at what was in the most recent release:

#1: While the Fed’s official stance is that interest rates will remain unchanged in 2019, the Dot Plot of individual Fed officials shows a more nuanced story:

  • Eight Fed officials have “dots” at 2.25% – 2.50%, the current rate.
  • Seven policymakers are at 1.75% – 2.00%, or 50 basis points below current levels.
  • In the March SEP, no policymakers saw the need for a rate cut in 2019.

Takeaway: not all “dots” represent voting FOMC members, but assuming a random distribution there is clearly a broad assumption among the committee that it will be appropriate to cut rates by 50 bp this year. This broadly fits with Fed Funds Futures prices, as we described in the Markets section. Swing a few more policymakers to a dovish stance, add a little more economic uncertainty, and you get exactly what futures have as their base case.

#2: The Fed has downgraded its expectations for inflation and is less optimistic about how long it will take to get to its 2% target rate:

  • Policymakers downgraded their estimate of PCE inflation from 1.8% in March to 1.5% now. Core inflation expectations are now 1.8%, down from 2.0% in March.
  • Even with optimistic assessments for GDP growth (2.0% this year, 2.0% next) and unemployment (3.6% this year, 3.7% next), the Fed does not expect to achieve its 2% mandate until 2021. In the March SEP, they were looking for 2% next year.
  • Even in 2016, when PCE expectations were for just 1.3%, the Fed was expecting to see it rise to 1.9% in the following year.

Takeaway: this did not get much attention today, but to our thinking these reduced expectations clear the way for the rate cuts the market is expecting.Recessions tend to be deflationary unless they come from an oil shock. And no central banker wants to replicate the deflationary spiral we’ve seen in Japan, for example.

#3: Fed policymakers have quietly cut their estimate of “neutral” interest rates – neither accommodative nor restrictive – by 50 basis points in less than a year:

  • In September 2018, 3.0% was the group’s mean estimate for “longer run” Fed Funds rates.
  • Now, it is 2.5% and down from 2.8% in the March SEP.

Takeaway: this was a hot topic a few months ago when the Fed was still talking about rate hikes this year, and this sizable a revision in such a short period of time shows a marked changed of thinking on their part.

In summary, today’s Summary of Economic Projections fits with the market’s view on rates even if the headlines do not.

Sources:

Fed Economic projections: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20190619.pdf

New York “Fed Drift” research: https://libertystreeteconomics.newyorkfed.org/2018/11/the-pre-fomc-announcement-drift-more-recent-evidence.html