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Is the Fed Running an Equity Test?

Posted by Joseph Trevisani on May 18, 2016 7:57:59 PM

When the Federal Reserve raised the Fed Funds rate in December the equity reaction was so severe that the FOMC refrained from action for six months.

The Fed is again hinting that it may hike again in June if U.S. statistics cooperate.

"Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June."

The economic conditions in one month are not likely to be materially different than they are now or were at the April 27th Fed meeting described in the above quote from the Fed minutes.

The only statistics that matter are the performance of the equity markets here and overseas.

Today's minutes and recent speeches and comments from Dennis Lockhart of the Atlanta Fed, John Williams of San Francisco, Robert Kaplan of Dallas and Eric Rosengren of Boston, all maintaining that a rate increase in June is possible, are a test.

The New York Fed's President Bill Dudley will likely continue the trial on Thursday in his presentation and Q&A session on Liberty Street in Manhattan.

Can the equity markets withstand higher rates? Not just a potential 0.25 percent fed funds increase but Treasury and commercial rates that will likely surge if the credit markets think that rate normalization has resumed. The yield on the 2-year Treasury gained six basis points and the 10-year added eight on Wednesday.

Equities initially sold off after the release of the FOMC minutes but the Dow and S&P closed flat, within points of their open.

The reaction of Asian and European equity markets, particularly in China will matter as much as those of the U.S. The last thing the Fed wants is a cascading worldwide sell-off in stocks. The equity wealth effect may not have added much to GDP but a collapse in equity prices will almost certainly damage economic activity worldwide and play havoc with consumer and investor confidence.

The take of the Chinese monetary authorities who control the Yuan will also matter. They PBOC mandarins may not say much but the Fed will be watching the action of the yuan. The Chinese currency has lost about 2 percent against the dollar since the end of March.

The dollar gained about 1 percent against the euro and 1.4 percent versus the yen on Wednesday.

Now that the Fed has deliberately and ostentatiously raised the possibility of a June hike, the governors could be in for a nervous few days as the markets work out the implications.

 

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Bloomberg

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