Market watchers were understandably focused on Fed Chair Powell's semi-annual monetary policy testimony to Congress this week. Most summaries of that testimony highlighted his dovish-minded position, emphasizing his view that the Fed will take a patient approach with monetary policy and that the Fed is close to agreeing on a plan to end the balance sheet runoff.
Those summaries were on conventional point, yet they all missed an opportunity to highlight the unconventional point that Mr. Powell simultaneously painted a case for the next rate hike.
Patience Is Trading Virtue
The stock market -- and Treasury market for that matter -- has latched onto Mr. Powell's stipulation that the Fed is going to be patient with its approach to policy.
For many market participants, being patient means not raising the target range for the fed funds rate again for a long time. In fact, the CME FedWatch Tool shows fed funds futures traders assigning almost no probability to another rate hike this year; moreover, the probability of a rate cut in January 2020 (11.2%) exceeds the probability of a rate hike (6.0%).
That is still some way away, yet there is no mistaking the fact that the fed funds futures market is not fearing the Fed. The stock and bond markets aren't really either.
That's an important point, because an attitude shift on the interest rate outlook could ultimately drive a material shift in both markets.
In other words, there is an inherent risk wrapped up in the complacency regarding the path of policy rates. That's why it is important to take stock of the rate-hike warning that was wrapped up in Mr. Powell's testimony.
It was not an explicit warning. Rather, it was a tacit one that got conveyed in the following paragraph of his prepared testimony:
"While we view current economic conditions as healthy and the economic outlook as favorable, over the past few months we have seen some crosscurrents and conflicting signals. Financial markets became more volatile toward year-end, and financial conditions are now less supportive of growth than they were earlier last year. Growth has slowed in some major foreign economies, particularly China and Europe. And uncertainty is elevated around several unresolved government policy issues, including Brexit and ongoing trade negotiations. We will carefully monitor these issues as they evolve."
Importantly, the Fed still views the economic outlook as favorable. Reading between that line, we'd say the Fed is still inclined at this juncture to raise the target range for the fed funds rate sometime this year more so than it is inclined to lower the target range for the fed funds rate.
Recall that the dot-plot released on December 19 -- less than three months ago -- revealed a median estimate among Fed members for two rate hikes in 2019. Everyone will be anxious to see if that median estimate gets dialed back when the Fed releases an updated dot plot following its March 19-20 FOMC meeting.
The market seems to be assuming that will be the case; and it is also beginning to think the Fed will reveal its plan for ending its balance sheet runoff by the end of the year.
Those are fair assumptions. Between the two, we think it is more likely that the Fed will release a plan for ending its balance sheet runoff.
From One Realm to Another
Mr. Powell, and others, have said repeatedly that they will be watching incoming data very closely to determine the proper course for monetary policy. They see risks out there that suggest it is prudent to be patient at this juncture, but what if those risks dissipate?
It's not out of the realm of possibility, which means the stock and bond markets would go back into the realm of fearing the Fed.
What could change the Fed's patient mindset? The answers are incubating in that passage from Mr. Powell's testimony.
--Financial markets became more volatile toward year-end
Volatility in financial markets, and particularly the stock market, has come down sharply. The Fed has itself to thank (and maybe one day to blame) for that, as it restored the notion of the "Fed put" with Fed Chair Powell's "patient" declaration on January 4. The CBOE Volatility Index, which closed at 25.45 on January 3, has plummeted 46% since then to 13.70.
The S&P 500, meanwhile, is up 14.3% since January 3 (and up 19% since Dec. 24).
--Growth has slowed in some major foreign economies, particularly China and Europe.
There is no denying that economic fact. At the same time, there is no denying that the Fed would welcome a pickup in growth in China and Europe. That's why data from both areas needs to be watched carefully, because if it starts picking up, so will the chances of a rate hike from the Fed if a pickup in growth abroad feeds stronger U.S. growth.
-- And uncertainty is elevated around several unresolved government policy issues, including Brexit and ongoing trade negotiations.
How Brexit gets handled is still anyone's best guess. The parties closest to the situation still don't know, but the issue is coming to an important head with the March 29 divorce date looming. A "no-deal Brexit" is deemed a worst-case scenario, yet it's a scenario the UK seems increasingly eager to avoid. The strengthening British pound of late has suggested as much.
If the UK can avoid the worst-case scenario, it will qualify as a positive simply because it removes the worst-case scenario from a tense situation. That could mitigate the worst of the uncertainty right now and subsequently foster better growth in the UK and European Union than there would be otherwise if the worst-case scenario came to fruition.
Similarly, the narrative out of Washington seems to suggest that the U.S. and China are angling to avoid a worst-case scenario in their trade dispute. The stock market has already responded quite favorably to this possibility. If it comes to fruition in the form of a trade agreement to refrain from raising tariff rates further -- or even cutting them -- it should provide a boost to global economic growth. In doing so, that would help the U.S. economy evolve in a positive way that validates the Fed's base-case scenario for why it sees the potential for two rates hikes in 2019.
What It All Means
The stock market has been an absolute beast in 2019. Some might even call it a bull. It's acting great in large part because it isn't fearing the Fed.
Ironically, one can make a case that the stock market is rallying itself into another rate hike that it desperately did not want in December.
Cyclical sectors have powered the best start to a year for the S&P 500 since 1991. They shouldn't be doing as well as they have been doing unless there was confidence in the view that the global economy, and the U.S. economy, was going to improve.
And why would that view take shape?
The Fed is sounding friendly; the trade negotiations between the U.S. and China are sounding hopeful; copper prices are rising; the Chinese stock market is up 20%; and economic data from the world's largest economy have been better than feared.
The Fed has expressed its willingness to be patient with its monetary policy, but if things continue their current course, that patience may be tested, and Fed officials may start using broad strokes again to paint the case for a rate hike that no one sees coming right now.