September 21, 2017

Stocks opened modestly lower this morning (Dow -37 pts; SPX -.15%) after nine straight days of gains. Telecoms are down after strong gains in the first half of the month. Semiconductors are down .5% and retailers are down .3%. On the other hand, banks are trading higher after yesterday’s Fed meeting. In fact, the KBW Bank Index is up 8% over the last two weeks responding to higher interest rates. The dollar is weaker today against a basket of foreign currencies, which usually means commodities are trading higher. But not today. Copper is down 1% (and 6% so far this month); gold is down .5%; iron ore is down 15% this month. WTI crude oil is trading flat today around $50.60/barrel. Bonds are mostly unchanged this morning. The 5-year and 10-year Treasury yields are hovering around 1.88% and 2.27%, respectively. The 2-year Treasury, which correlates more with Fed policies, is up to a nine-year high.

Yesterday, the Federal Reserve finished its monthly meeting and announced plans to continue unwinding its recession-era monetary stimulus. The process, as you may recall, began in December 2015 when the Fed began lifting its short-term Fed-funds interest rate from 0%. The rate has gradually floated up to about 1.16% today. Now we’re entering into a new phase of the unwind, which includes more rate hikes and also reduction of the Fed’s $4.6 trillion balance sheet. Yesterday’s announcement detailed the plan: about $10bil of Treasury and mortgage-backed bonds will be allowed to mature each month, and going forward the amount of balance sheet runoff will increase by $10bil each quarter. 

The announcement also confirmed status quo for the economy. Inflation remains low, and economic growth is expected to hover around 2% for the next couple of years. But at the same time, most Fed officials expect another .25% hike in the Fed-funds interest rate before year-end, and three more hikes next year. The ultimate target—two years away—for that rate is 2.75%. Keep in mind, the much longer-term 10-year Treasury note yield is at 2.27% now. So there is clearly a disconnect here. Monetary policy tightening will accelerate even as the economy is expected to remain static. Usually, tightening monetary policy is a reaction to an overheating economy. 

My sense, based on the market reaction today, is that most investors don’t believe the Fed will be that aggressive. Scott Minerd of Guggenheim Partners and Bill Gross of Janus Capital both say that if the Federal Reserve slavishly follows this path of monetary tightening, it will likely lead to an economic recession in about two years. 

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