Are the Fed and financial markets “out of sync” again?

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In Short

The drop in US equities and rise in bond yields that followed Jerome Powell’s comments this week suggest that the Federal Reserve and the financial markets are at risk of becoming out of sync once again, potentially repeating last October’s events.

On this issue we believe that the market’s reaction reflects a build-up of unwarranted expectations about an “insurance interest rate cut” rather than a more fundamental reassessment of Fed policy.

Before this week’s meeting of the Federal Open Market Committee few doubted that the Fed would pause interest rates for now. Far more important were the signals made about their future path. Ahead of the FOMC meeting, a speech by Charles Evans of the Chicago Fed fuelled speculation of an “insurance cut”, a strategy that – according to Evans – the Fed used during the 1997-8 rate-hiking cycle. This was reflected in the divergence between market pricing for interest rates and the FOMC projections. In the press conference yesterday, Chairman Powell’s comments setting out the high threshold for an interest rate cut reset expectations towards the FOMC projections.

Chart shows Federal Funds Rate (bps)

We continue to believe that the evolution of economic data is likely to be more important in determining outlook for asset markets. However, we now expect financial markets to be more sensitive to negative economic data than had been the case earlier this year, reflecting the higher threshold for a central bank reaction.

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