Fed Crying Wolf Risks Losing Investor Faith in Policy Rate Path

Most Important Two Minutes of Yellen's Statement
  • Yield on two-year Treasuries sinks to lowest since February
  • “Policy makers’ comments have a limited shelf life”: Piegza

It’s the Fed that cried wolf.

QuickTake The Fed Lifts Off

After U.S. central bank officials including Chair Janet Yellen signaled for weeks that they expected to raise interest rates in coming months, backing previous forecasts that called for two increases this year, the Federal Reserve on Wednesday lowered its borrowing-cost trajectory. The revisions came even as projections for U.S. economic growth and inflation were left little changed.

For investors who had already discounted the Fed’s prior projections, the changes are another blow to their faith in the central bank’s ability to communicate the path of rates. So far this year, traders have predicted a slower pace of hikes, with Treasuries rallying and Fed fund futures signaling just a 37 percent chance of one increase to interest rates in 2016.

“It seems as though the Fed is a bit lost and trying to find their way,” said Robert Pavlik, who helps oversee $9.1 billion as chief market strategist at Boston Private Wealth. “They seem almost as confused as the rest of the market in terms of their projections and guidance. They’re in a leadership role, and if you associate that with credibility, it’s definitely being called into question.”

While the median forecast of 17 policy makers remained at two quarter-point hikes this year, the number of officials who see just a single move rose to six, from one in March, according to Fed projections. The committee left their target range for the benchmark federal funds rate unchanged at 0.25 percent to 0.5 percent. Traders had ruled out the possibility of a rate hike this month after a June 3 report showed employers in May added the fewest new jobs in almost six years.

“The market is increasingly skeptical of what the Fed says,” said Ward McCarthy, the chief financial economist at Jefferies Group LLC. “The last couple weeks the Fed was pushing that they’d be raising rates in the months ahead, and then they go and lower their projections drastically.”

Officials including San Francisco Fed President John Williams and Atlanta Fed President Dennis Lockhart said last month that two or three rate increases were possible this year. Minutes from the Fed’s April meeting, released May 18, showed most officials said a June move would be warranted if economic data indicated stronger growth and inflation, causing futures traders to boost wagers on a hike this year. In a May 27 speech at Harvard University, Yellen said an increase would likely be appropriate “in the coming months.”

“The Fed continues to voice a bit of a hawkish tone when officials are speaking on the circuit, and everyone interprets that as that’s the Fed next move,” said Tom di Galoma, managing director of government trading and strategy at investment bank Seaport Global Holdings LLC in New York. “But that’s not necessarily the way it goes. Wednesday it was all about the dots.”

Fed Projections

Officials also slowed the pace of expected moves in both 2017 and 2018: They now only foresee three increases in each of those years, down from the four they expected in March. In a press conference Wednesday, Yellen spoke of a sense that rates may be depressed by “factors that are not going to be rapidly disappearing, but will be part of the new normal.”

In the U.S. stock market, bulls couldn’t hold on to what would’ve been the first advance in five days, surrendering to selling pressure that built throughout Yellen’s testimony. The S&P 500 Index ended 0.2 percent lower.

The yield on the two-year Treasury note, the coupon maturity most sensitive to Fed policy, fell to the lowest since February. Yields on U.S. debt due in a decade have dropped 71 basis points since Dec. 31 to 1.56 percent, confounding analysts who had forecast that they would climb to 2.60 percent by June 30.

Market Skepticism

“If you read the release today they basically pushed the spaghetti around the plate -- the strengths and weaknesses just shifted,” said Anna Rathbun, director of research for CBIZ Inc.’s retirement-plan services unit in Cleveland. “The Fed is trying to get the market ready for a possible rate hike but the market is quick to dim that possibility. There is a ‘boy who cried wolf’ effect with the Fed.”

The dollar fell versus most major currencies Wednesday on the Fed’s dovish stance. The Bloomberg Dollar Spot Index has declined 3.8 percent this year, after surging 25 percent from mid-2014 through a January peak.

“If we learned anything from the April-June bait and switch it is that policy makers’ comments have a limited shelf life and in no way represent a commitment to act on said comments at the next FOMC meeting," said Lindsey Piegza, chief economist at Stifel Nicolaus & Co., in e-mailed comments. “The Fed can only yell ‘strong economy’ so many times without taking action before the market stops listening entirely."

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