Having triggered the bond market's recent selloff, the
seemingly went out of its way to please the fixed-income crowd Tuesday. The tricky thing was doing so without unnerving equity market participants. In the end, the central bankers were only partially successful.
The central bank's comments about the economy and its pledge to keep rates low for the foreseeable future aided the stock market, which rallied sharply after the Fed's announcement at 2:15 p.m. EDT. But fixed-income traders gave the Fed something of a cold shoulder, with long-dated Treasuries ending lower after a knee-jerk rally following the announcement.
As was widely expected, the Federal Open Market Committee left its target fed funds rate unchanged at 1%. Somewhat unexpectedly -- given growing confidence in the economy and speculation about when the Fed might tighten -- the
accompanying statement revived the specter of deflation and declared it will leave rates unchanged for a "considerable period."
Noting "business pricing power and increases in core consumer prices remain muted," the Fed declared again "the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future."
Despite suggesting the balance of upside vs. downside risks facing the economy are "roughly equal," the Fed reiterated a warning that "the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level."
Subtraction and Addition
The verbiage was nearly identical to the Fed's
June 25 statement, with one notable exception. The word "substantial" was omitted as a modifier to the phrase "unwelcome fall in inflation," after having been included previously.
The Fed is trying to "re-educate us" as to what levels of inflation can exist while price stability is maintained, said William Tedford, director of fixed income at Stephens Capital Management, which runs about $700 million in intermediate-term bond funds.
"They're not talking deflation but that inflation is not a problem," Tedford said, referring to a July 23
speech by Fed governor Ben Bernanke. "They're giving themselves cover to keep the fed funds rate at 1% until they can get the economy growing and want to keep inflation expectations from pushing rates up, which mitigates their efforts."
While omitting the word "substantial," the Fed also added a sentence to Tuesday's statement that was missing on June 25: "In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period."
Peter Kretzmer, senior economist at Bank of America, suggested that was the Fed's "most direct meeting statement yet that it intends to keep rates low for an extended period."
The additional sentence quelled concerns that the Fed would soon contemplate raising rates, and helped the
Dow Jones Industrial Average
rise 1% to 9310.06 while the
gained 1% to 990.35 and the
climbed 1.5% to 1687.01.
All three major averages ended just a fraction below session highs, hit in the final minutes of trading. Breadth favored advancers by about 2 to 1 in both
and Nasdaq trading, but volume was below average in the former, at 1.1 billion shares.
In assuaging concerns about forthcoming rate hikes and reviving de/disinflation, the central bank effectively offered a peace pipe to the Treasury market. Many fixed-income players felt burned by the Fed, which hinted about taking extraordinary policy measures in the spring, leading to generational low Treasury yields in early June. But the bond "bubble" burst after the deflation/disinflation risks were downplayed at the June FOMC meeting, Chairman Alan Greenspan's congressional testimony on July 15-16, and subsequent other pronouncements by various Fed members.
"We deem the Fed's cautious view on deflationary risks as mainly a device to prevent further run-up in yields rather than a reflection of the central bank's cautiousness with price deceleration," opined Ashraf Laidi, chief currency analyst at MG Financial Group.
While up fractionally vs. the yen, the dollar rallied sharply vs. the euro, which fell to $1.128 late Tuesday vs. $1.136 late Monday. Gold futures fell 0.4% to $360.30 per ounce while mining stocks were notable laggards. The Philadelphia Stock Exchange Gold & Silver Index fell 1.7%.
The Fed probably would be pleased by a combination of rising equities and greenback, plus falling gold. However, the central bank's efforts with the Treasury market were decidedly mixed.
Prices rose and yields fell at the short end of the Treasury curve, thanks to the promise of no rate hikes. But the benchmark 10-year note ended down 6/32 to 31/32, its yield rising to 4.38%, while the 30-year bond fell 25/32 to 100 24/32, its yield rising to 5.32%.
A Box of Its Own Making
In sum, Tuesday's FOMC statement was open to varied interpretations. Those looking for signs of optimism about the economy could point to the comment that spending is "firming" and how the "accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity."
Apparently, this upbeat assessment and the likelihood of no rate hikes is what equity investors focused on -- along with better-than-expected earnings from firms such as
, and positive news about default rates from
Capital One Financial
Those looking for signs of caution could cite the aforementioned comments about the risks of deflation, a term the Fed didn't actually use. Also, while the Fed said labor markets had "stabilized" in June, they were declared to be merely "mixed" on Tuesday.
Presuming the Fed wants to be nuanced and somewhat obscure, Tuesday could thus be viewed as a success for Alan Greenspan & Co. However, the Greenspan Fed has embraced the notion of transparency and is finding that being an "open Fed" has its drawbacks. By publicly sharing its thoughts about deflation and zero-rate environments in the past year, the Fed created rampant bullishness in the Treasury market. Now, the central bank is trying to clean up the mess it created after fixed-income traders realized their zeal was unwarranted. (Cleaning up after itself is something this Fed often has to do).
On some (simple and cynical) level, the Fed's intent Tuesday was to stop the selloff in Treasuries by reintroducing the concept of deflation into the financial markets' consciousness. But the Fed hoped to do so in a way that wouldn't spook the equity markets.
Judging by the markets' reaction, the Fed was only halfway successful. It had the "wrong" half (the stock market) listening to its message, and it was listening to the wrong part of it -- wrong for those hoping to see signs of a more sustained and steady economic recovery, that is.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.