The Federal Reserve answered the market's cry for it to acknowledge inflation, but also to acknowledge the risks of more rate hikes to the slowing economy. The result was a sharp rally in stock and bond prices.
Dow Jones Industrial Average
was up about 86 points ahead of the Fed's 2:15 p.m. EDT announcement; it jumped to triple-digit gains as soon as the statement came out. The Dow ended the day up 2%, or 216.44 points, at 11,190, while the
gained 2.1% to 1272.39; the
climbed 2.8% to 2170.53.
"In the short term,
the Fed statement was exactly what the market wanted to hear," said Drew Matus, senior economist at Lehman Brothers.
But recent history suggests every time the market perceives the Fed as becoming more dovish, the central bank comes out and tells the markets they got it wrong.
Ben Bernanke came out and said so directly to
Maria Bartiromo after his congressional testimony in April. And, after markets interpreted the word "yet" as dovish in the May 10 FOMC statement, the Fed came out and stunned the market with intense inflation-fighting rhetoric. Thursday's statement can only be read as more dovish than expected, and allowing flexibility for a possible pause. But investors should be cautious about counting on it.
The Fed added another 25 basis points to the fed funds rate, as was widely expected, bringing in the funds rate to 5.25%.
"Readings on core inflation have been elevated in recent months," reads the accompanying statement, adding that "the moderation in the growth of aggregate demand should help to limit inflation pressures over time."
On the question of further hikes, the Fed said it will remain data dependent, but the language was less formulaic. Thursday's statement reads: "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
May's FOMC statement read: "Some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook."
"Hoorah," the market cried.
The Dow's best-performing stock was
, which soared 4.6% on a Merrill Lynch upgrade. Some of the sectors that rallied sharpest Thursday were those that had fallen hardest in the market's June swoon, including the Dow Jones transports and commodities-related stocks such as
The transports index gained 3.4% to 4890.23, only 2.17% from its all-time high hit last Month.
Volume was bullish Thursday. The Nasdaq saw 90% of its volume to the upside -- "a rare and beautiful thing," says Alex Grace, trader and hedge fund consultant. The
saw 81% of its stocks advance.
Commodities prices again rose in concert with the stock market. Crude oil gained 1.8% to close at $73.52 per barrel, while gold gained 1.3% to $588.90 per ounce. Silver gained 1.9% to close at $10.45 per ounce, and copper rose 4% to $3.32 per pound.
Some warned that the stock market's jump ahead of the Fed meeting was unusual, as stocks are typically flat on FOMC days. The daylong rally could in part be due to quarter-end maneuvering and investors covering short-positions. In addition to the impact of quarter-end portfolio adjustments, the Russell 3000 rebalancing happens Friday as well.
"I would caution getting overly excited that this means a pause," says Bill Mulvihill, senior economist at First Trust Advisors.
Mulvihill predicts the fed funds rate goes to 6% by the end of the year on the back of a strong economy and inflation pressures. Others have joined the 6% camp as the flood of inflation data and Fed-speak suggests the central bank will not hesitate to push the envelope on the economy to fight inflation. The deadline varies, however, with most economists pushing the 6% level to the middle of next year. That said, most economists expect the Fed to end its now two-year tightening campaign with fed funds at 5.5% or 5.75% given expectations for economic data to support more inflation-fighting.
The fed funds futures market is now less convinced about an August hike, however. The futures market sharply reduced the likelihood of an August rate hike to 62% from over 80% earlier in the week.
The Treasury bond yield curve flattened Thursday, also reflecting some conviction in the bond market that the Fed may indeed be ready to pause. Treasuries reacted to the FOMC statement with a rally after slumping for more than a week. The 10-year Treasury note was up 10/32 in price to yield 5.20%, while the two-year Treasury bond gained 5/32 to yield 5.20% as well.
As expected, the dollar fell as expectations for higher rates fade. The euro gained 0.88% to $1.2659, while the dollar fell 1.01% vs. the yen to finish at 115.18 yen.
While the market may run with the FOMC statement for a while, there are risks to the Fed's dovish tone. For one, it doesn't jive with its recent barrage of ultra-hawkish Fed-speak. Indeed, many in the market expected the Fed to come down hard on inflation in the FOMC statement and the lack thereof was a catalyst for Thursday's rally.
But in the long term, that inconsistency means there is some risk to the Fed's policy decision-making, says Matus, adding that the Fed may be too dependent on its own economic forecast to determine policy whichever direction that may be. In the meantime, the bulls can enjoy the occasional happy summer day.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
to send her an email.