9 Bullets

Imagine you’re huddled down in a bunker, with the enemy approaching, and you only have nine bullets left. Do you fire a preemptive shot or two, hoping it will deter the enemy? Or do you save those bullets and wait patiently until you’re sure an attack is imminent?

That’s the situation the Federal Reserve is facing right now. Over the last few years, they’ve managed to stockpile nine bullets (rate cuts) to be used in the event of a downturn. Now, with global economic conditions slowly deteriorating, and no end to the trade war in sight, they have to decide exactly how to use those nine bullets.

The market, which is typically comprised of “shoot first, ask questions later” types, has begun to price in a strong likelihood of those preemptive shots being fired. As a result, it has already been rallying on the back of anticipated monetary easing. But is the market getting ahead of itself?

Two weeks ago, the market turned on a dime as Mr. Powell told investors that the Fed would, “act as appropriate to sustain the expansion.” It appears that market participants took this as a sign that rate cuts were imminent, bidding up fed funds futures to reflect the possibility of up to four rate hikes in the back half of the year.

Target Rate Probabilities Fed Meeting

This pack of classically conditioned dogs is salivating for easier monetary policy, and will rejoice if they get it … but what if they don’t? What if Pavlov decides not to ring the dinner bell? In that case, we’re likely to see some form of a temper tantrum.

So predicting the near-term direction of stock prices likely hinges on the messaging that comes from the Federal Reserve tomorrow, following the completion of their two-day FOMC meeting. This will be an eventful meeting for a variety of reasons, which we’ll get into.

First, I’d like to provide some background on the Fed’s dual mandate, and explain why it’s possible the market is getting ahead of itself. As you know, the Fed is tasked by congress with two main objectives, maximizing employment, and maintaining price stability.

With the country experiencing nearly the lowest unemployment in history, it’s difficult to argue that the employment mandate is not being met. Thus, all hopes for a rate cut hinge on the inflation side of the equation.

Back in 2012, the Fed officially set its inflation target (a self-created definition of “price stability”) at 2%. But as you can see below, over the past year inflation has fallen well below that target … or has it?

Personal Consumption Expenditures (PCE) Headline and Core

When monitoring inflation, the Fed prefers to use the year-over-year change in personal consumption expenditures (chart above) to gauge inflation. More specifically, they like to use the “core” version of this metric, which excludes volatile food and energy prices.

This brings up an interesting question. Why, exactly, does the Fed want to strip out volatile food and energy prices from their inflation readings when calibrating monetary policy? The answer is that the Fed is trying to understand and react to the economy’s underlying cyclical nature, not temporary price changes caused by one-off events. In other words, they’re trying to separate the signal from the noise, so they can react appropriately.

That’s the main reason why investors pay more attention to core inflation than the headline reading when anticipating Fed monetary policy moves. But is there a better alternative?

Every once in a while when Fed officials speak, you’ll hear them refer to a cryptic measure of inflation known as the Trimmed Mean PCE Inflation Rate. I’d like to explain this metric in more detail today, because it presents an argument as to why the Fed may NOT react as dovishly to current economic conditions as many investors expect.

As mentioned above, the goal of monitoring inflation is to get a reading on the cyclical state of the economy. Just as the Fed doesn’t want to react to a weather driven shortage of soybeans, which pushes food prices up, they also don’t want to react to things like price-wars between wireless phone providers, as we saw late last year. In both cases, these are temporary events driven by factors unrelated to underlying economic cyclicality.

But since wireless phones don’t qualify as either food or energy, their prices get wrapped into core inflation figures, as do many other volatile price categories. This is why the Dallas Fed created the Trimmed Mean PCE Inflation Rate.

Rather than simply excluding food and energy, this measure of inflation strips out the categories with the most extreme price changes each month, resulting in what some consider to be a better gauge of underlying inflation.

For those who are statistically inclined, the reason this approach is believed to be a better alternative is because the distribution of price changes is “fat tailed.” That is, similar to stock price returns, there are many more observations at extreme high and low values than one would expect based on a normal distribution.

In situations like this, where fat tails exist, the average price change observed in any given month is a poor estimate of the distribution’s central tendency. The accuracy of that average can be improved by “trimming” off the observations from the tails, which is exactly what the Trimmed Mean PCE Inflation Rate does.

To give you an idea of the real life implications of this, consider the chart below. This chart shows the behavior of the Core PCE inflation rate in red, and the Trimmed Mean PCE inflation rate in blue.

Two Measures of Inflation: Core PCE and Trimmed Mean PCE

Notice that on two separate occasions since 2012, core inflation has diverged from the Trimmed Mean inflation rate before reversing course. In both of these instances, core inflation realigned itself with the Trimmed Mean value, indicating that the Trimmed Mean PCE inflation rate was correct in identifying the downward moves in core inflation as transitory.

If you’ve watched any of the post-FOMC press conferences in recent years, you know that this concept of transitory inflation is mentioned frequently. Hopefully this exercise will reinforce exactly what Fed officials are referring to when they use that term.

Moving on, you can see at the right side of the chart above that we’re at the beginning of another divergence between these two inflation metrics. Core inflation is heading lower, suggesting an increased possibility of Fed rate cuts, while Trimmed Mean inflation remains stable.

This begs the question, which metric is the Fed most likely to defer to? Unfortunately, I don’t have an answer to that, but it seems to me the Fed does have justification to NOT placate the market with as many rate cuts as the market currently expects. This is the same view espoused by strategists at Goldman Sachs and JP Morgan Chase, who have warned that expectations of a summer rate cut are overblown.

So, getting back to our original discussion, what exactly will the Fed do with its nine remaining bullets? My best guess is that the Fed, ever worried about the zero bound, will probably be reluctant to fire those bullets until they’re sure the firepower is needed. This may place the market at odds with the Fed, and could act to undo much of the recent Fed-induced rally.

The other thing to consider is that we’re faced with a handful of (essentially) binary events when it comes to trade. Were the Fed to cut rates aggressively, only to find that economic prospects ramp up quickly as a result of a trade deal, it would be like firing preemptive shots only to find out it was friendlies approaching. That would leave the Fed with mud on its face.

Adding to the confusion that may arise from tomorrow’s decision, where a rate cut is not expected, is the Fed’s communication tool known as the dot plot. The dot plot contains a projection of each Fed member’s expectation for the near-term direction of the federal funds rate.

The dot plot was introduced in 2012 as a way to communicate to investors that rates would stay low for much longer than originally thought. Since then, it has only been used to signal the path of anticipated interest rate hikes.

So the big question for tomorrow’s meeting is whether the dot plot will now be used to communicate the likelihood of rate cuts. This tool is widely watched by market participants, and one can imagine the reconciliation (read: market volatility) that will take place if the market is expecting two or three rate cuts this year and the Fed’s dot plot suggests something contrary.

Overall, with this being a critical FOMC meeting in terms of communication, and the market seemingly expecting more dovishness than warranted by some of the data, my preference is to error on the side of caution rather than bullishness.

Let’s end with a quick look at the charts. Shown below, the S&P 500 gapped higher today on the back of renewed trade hopes. It’s within spitting distance of its all-time high.

S&P 500 Index

The Industrials (top panel below) are similarly near their all-time highs, however the Transports (lower panel) are struggling to gain traction. Should this divergence continue, it could leave us with a Dow Theory non-confirmation soon.

Dow Theory: Industrials and Transports

As for market internals, they actually remain quite strong. The NYSE Advance-Decline line, picture below, is at new all-time highs.

NYSE Advance-Decline Line

But there is an interesting fly in the ointment … The common-stock only version of this metric has not surpassed its early May high. This means that the push to new highs seen above is being driven by bond-related issues, which typically move higher as interest rates move lower.

NYSE Common Stock Only Advance-Decline Line

Keep in mind there is no major significance to this divergence, as it could be quickly reversed (and major averages aren’t at new highs anyway), but it’s something to be mindful of.

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