"This Is Not The Reaction The Fed Wanted": Goldman Warns Yellen Has Lost Control Of The Market
With stocks soaring briskly around the globe following Yellen's "dovish" hike, and futures set for a sharply higher open with the Nasdaq approaching 6,000, something surprising caught our attention: in a note by Goldman's Jan Hatzius, the chief economist warns that the market is overinterpreting the Fed's statement, and Yellen's presser, and cautions that it was not meant to be the "dovish surprise" the market took it to be.
Specifically, he says that while the FOMC delivered the expected 25bp hike, with only minor changes to its projections. "surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices."
Even more surprisng is that according to Goldman, its financial conditions index, "eased sharply, by the equivalent of almost one full cut in the federal funds rate."
In other words, the Fed's 0.25% rate hike had the same effect as a 0.25% race cut!
The implication from the market's reaction is that at current levels, financial conditions are poised to make a substantial positive contribution to growth in 2017, from a starting point of essentially full employment, inflation close to the target, and a sub-1% funds rate; which in light of concerns about an economic overheating due to Trump's fiscal policies is precisely the opposite of what Yellen wants. Hatzius warns that "the FOMC will lean against this, and will deliver more monetary tightening than discounted in the bond market."
It gets better: Goldman's chief economist - like virtually all other carbon-based market participants - admits he was stunned by the market reaction to the Fed rate hike. While Hatzius agrees that the general direction of the market response makes sense, "the magnitude greatly surprised us" and adds that Wednesday's price action was scored by Goldman's models "as the third-biggest dovish surprise at an FOMC meeting since 2000, at least outside the financial crisis."
And the punchline: when asked rhetoricall if "the FOMC was aiming for this outcome?", Hatzius says "No, almost certainly not."
The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.
In other words, whether on purpose or otherwise, according to Goldman the Fed, which now wants to tighten financial conditions (i.e., see asset prices lower) not only achieved the opposite, but has now lost control of the market.
So "how will the committee respond to this potentially undesired move?"
At the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.
Our modal forecast remains for a total of three hikes this year, with remaining moves at the meetings in June and September, followed by four hikes each in 2018 and 2019. We see a 60% subjective probability that the next hike occurs at the June 2017 meeting, 10% for July, and 20% for September. We also expect an announcement of gradual balance sheet rundown in December; if this does not occur, the likelihood of a fourth 2017 hike would increase.
Of course, if the first of two, three or four rate hikes in 2017 is any indication, the market, already sloshing in trillions of excess liquidity, will simply take the Fed's next tightening as an indicator of easing, and send risk assets to even more obscene highs.