The third week of March 2017 was an up week for the S&P 500, where the index closed at 2,378.25 on Friday, 17 March 2017, just 5.65 points (0.24%) above where it closed at the end of the prior week of trading.
In the middle of the week that was Week 3 of March 2017, the Fed followed through and did exactly what it had been strongly signalling that it would do over the last several weeks, and boosted short term interest rates by a quarter percent, putting the Federal Funds Rate into a range between 0.75% and 1.00%.
That doesn't mean however that we weren't surprised. For the Fed to have drawn such a strong focus where it would be using its influence to affect the expectations that investors have for the future, we should have seen a stronger upward movement in U.S. stock prices on Wednesday, 15 March 2017 that what the market saw.
That's because nearly all the Fed's officials have been doing everything they can to set the expectation that they will be hiking U.S. interest rates again in the very near future, which would put the timing of their next hike sometime in 2017-Q2, and which would most likely be announced at the end of the FOMC's June 2017 meeting.
Given where stock prices have been, since the expectations for the change in the year over year growth rates for S&P 500 dividends would place the S&P 500 higher than it currently is, for the Fed to have been successful in setting that focus would have coincided with a much larger jump in stock prices than what was recorded on Wednesday, 15 March 2017. At the very least, it should have moved to the middle of our echo-effect adjusted forecast range (indicated by the red-lined box on the chart above).
We would have expected that result because we have observed exactly that kind of behavior in stock prices following previous FOMC's meetings where the Fed has directed the attention of investors to focus upon specific points of time in the future. So much so that we've used the timing of the FOMC's announcements to check the calibration of our dividend futures-based forecasting model.
So what gives now in Week 3 of March 2017? Why would stock prices appear to be behaving differently now than they have on the occasion of the Fed's previous announcements? Why would stock prices stay so much lower than what we would expect from even our echo-effect adjusted forecast?
We think the key to understanding what's going on with stock prices came out during Janet Yellen's post-FOMC announcement press conference, where Bloomberg's Kathryn Hays asked a pointed question:
KATHLEEN HAYS. Chair Yellen, Kathleen Hays. Oh excuse me, Kathleen Hays from Bloomberg. I'm going to try to take the opposite side of this because, on this question about market expectations and how the markets got things wrong, and then how you say the Fed suddenly clarified what it already said. But, for example, if the–if you look at the Atlanta Fed's latest GDP tracker for the first quarter, it's down to 0.9 percent. We had a retail sales report that was mixed, granted the, you know, upper divisions of previous months make it look better, but the consumer does not appear to be roaring in the first quarter, kind of underscoring the wait-and-see attitude you just mentioned. If you look at measures of labor compensation, you note in this statement that they're not moving up. And, in fact, they are–and if you look at average–there are so many things you can look at. And you, yourself, have said in the past that the fact that that is happening is perhaps an indication there's still slack in the labor market. I guess my question is this, in another sense, what happened between December and March? GDP is tracking very low. Measures of labor to compensation are not threatening to boost inflation any time fast. The consumer is not picking up very much. Fiscal policy–we don't know what's going to happen with Donald Trump. And, yet, you have to raise rates now. So what is the, what is the motivation here? The economy is so far from your forecast, in terms of GDP, why does the Fed have to move now? What is this signal, then, about the rest of the year?
CHAIR YELLEN. So, GDP is a pretty noisy indicator. If one averages through several quarters, I would describe our economy as one that has been growing around 2 percent per year. And, as you can see from our projections, we, that's something we expect to continue over the next couple of years. Now that pace of growth has been consistent with a pace of job creation that is more rapid than what is sustainable if labor force participation begins to move down in line with what we see as its longer run trend with an aging population. Now, unemployment hasn't moved that much, in part because people have been drawn into the labor force. Labor force participation, as I mentioned in my remarks, has been about flat over the last 3 years. So, in that sense, the economy has shown, over the last several years, that it may have had more room to run than some people might have estimated, and that's been good. It’s meant we've had a great deal of job creation over these years. And there could be, there could be room left for that to play out further. In fact, look, policy remains accommodative. We expect further improvement in the labor market. We expect the unemployment rate to move down further, and to stay down for the next several years. So, we do expect that the path of policy we think is appropriate is one that is going to lead to some further strengthening in the labor market.
KATHLEEN HAYS. Just quickly then, I just want to underscore. I want to ask you, so following on that, you expect it to move. What if it doesn't? What if GDP doesn't pick up? What if you don't see wage measures rising? What if you don't, what if the core PCE gets stuck at 1.7 percent, would you, is it your view, perhaps, that if there's a risk right now in the median forecast for dots, that it's fewer hikes this year rather than the consensus or more?
CHAIR YELLEN. Well, look, our policy is not set in stone. It is data dependent and we're, we’re not locked into any particular policy path. Our, you know, as you said, the data have not notably strengthened. I, there's noise always in the data from quarter to quarter. But we haven't changed our view of the outlook. We think we're on the same path; not, we haven't boosted the outlook projected faster growth. We think we're moving along the same course we've been on, but it is one that involves gradual tightening in the labor market. I would describe some measures of wage growth as having moved up some. Some measures haven't moved up, but there's some evidence that wage growth is gradually moving up, which is also suggestive of a strengthening labor market. And we expect policy to remain accommodative now for some time. So we're, we’re talking about a gradual path of removing policy accommodation as the economy makes progress, moving toward neutral. But we're continuing to provide accommodation to the economy that's allowing it to grow at an above-trend pace that's consistent with further improvement in the labor market.
We're kind of in a unique position in that we recognized, very early in 2017-Q1, that the Fed could get away with hiking short term interest rates as they did during Week 3 of March 2017, with almost no negative effect from shifting the forward-looking focus of investors from 2017-Q2 (where it had been focused) to the nearer term future of 2017-Q1 because the expectations for changes in the year over year growth rate of dividends per share in 2017-Q1 have been nearly identical with the expectations for 2017-Q2 for months. That similarity between those sets of expectations has meant very little impact to stock prices for investors shifting their focus back and forth between the two quarters.
But that's also occurred as the lagging effects from the 2014-2016 economic slowdown have become more pronounced in the economic data, as described by Kathryn Hays in her question to Fed Chair Janet Yellen. That deterioration in the economic data is increasingly leading investors to set their attention toward 2017-Q3, which given where stock prices are today, would tend to weight them down, where investors are betting that the negative economic data will cause the Fed to back off from hiking short term interest rates again until that more distant future quarter.
The result then is a split in the forward-looking focus of investors, where they would appear to now be dividing their focus between 2017-Q2 and 2017-Q3 in setting today's stock prices, with the outcome of stock prices that have been mostly moving sideways to slightly upward.
In this environment however, otherwise minor news about that economic data that would ordinarily not be of much concern to investors can have an outsized impact. Good numbers on the economy will lead investors to favor 2017-Q2 for the timing of the Fed's next rate hike, with stock prices rising as a result. Bad numbers will tend to direct investors to focus on 2017-Q3, sending stock prices lower as they bet the Fed will delay its next rate hike.
That dynamic is setting up just as the S&P 500 is reaching a near record period of relatively low volatility, in which it hasn't seen a decline of at least 1% during the past 108 trading days. We think that's going to change in a very noticeable way in the very near future, especially as the underlying trajectories for the basic path of future stock prices is also about to change from generally upward to generally downward (more on that next week!) Until then, get ready to hang onto your hats!
The other news that stood out to us during the Week that Was Week 3 of March 2017 is linked below!
Elsewhere, Barry Ritholtz recaps the week's positives and negatives for the U.S. economy and markets.