When Hawks Cry

The inimitable US musician Prince (and yes, this was before he changed his stage name to a bizarre symbol , officially becoming “The Artist Formerly Known as Prince”) released the iconic song “When Doves Cry” way back in 1985.

Coincidentally, the song coincided with an aggressive rate-hike cycle from the Federal Reserve under the chairmanship of Paul Volker, a development that made monetary policy doves cry, figuratively speaking. If “The Artist Formerly Known as Prince” were to make a comeback under Janet Yellen’s Fed, however, he may want to rename his famous tune “When Hawks Cry.”

In their widely watched September policy meeting, the Federal Reserve chose to leave interest rates unchanged, marking the 55th meeting since the central bank last raised rates. Key headlines from the FOMC statement, Summary of Economic Projections and Dr. Yellen’s press conference are highlighted below (emphasis mine):

• FOMC: VOTE 9-1 IN FAVOR OF LEAVING INTEREST RATES UNCHANGED
• LACKER DISSENTS, WANTED 25 BPS HIKE
• FOMC: GLOBAL ECONOMY, FINANCIAL EVENTS 'MAY RESTRAIN ECONOMIC ACTIVITY'
• FOMC: LABOR MKT IMPROVED,'SOLID' JOB GAINS, UNEMPLOYMENT DECLINING
• FOMC LOWERS LONG-RUN EQUILIBRIUM FED FUNDS RATE ESTIMATE TO 3.5% (VS. 3.8% JUNE)
• FOMC: 11 PARTICIPANTS SEE FED FUNDS RATE BELOW 0.5% AT END 2015 VS 7 JUNE
• FOMC: ECONOMY WILL EXPAND MODERATE PACE W/ 'APPROPRIATE' ACCOMODATION
• FOMC: ONE PARTICIPANT SEES NEGATIVE FFR END-2015 & END-2016
• FED: MARKET-BASED MEASURES OF INFLATION COMPENSATION MOVED LOWER
• ARGUMENT COULD BE MADE FOR HIKES AT THIS TIME
• FED STILL EXPECTS INFLATION EFFECTS TO BE TRANSITORY
• EVERY MEETING IS A LIVE MEETING, THAT “CERTAINLY” INCLUDES OCT

As you can see, the central bank was nearly unanimous in favor of waiting to raise interest rates, with the recent volatility in financial markets and concerns about global growth as the primary catalysts for delaying. Digging into the central bank’s Summary of Economic Projections (SEP) reveals a much more cautious view on the US economy:

Source: Federal Reserve, FOREX.com

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The median Fed policy maker now expects core inflation to remain below the central bank’s 2% target until 2018 and the long-term non-accelerating-inflation rate of unemployment (NAIRU) has been revised down a tick to 4.9%, meaning that there is less urgency to hike interest rates to head off eventual inflationary pressures.

Perhaps the biggest shocker came from the so-called “dot chart,” which shows FOMC members’ expectations for interest rates over the next few years. One particularly dovish member of the FOMC (we don’t know who) actually believes the central bank should cut interest rates into negative territory until 2017. While this represents an extreme fringe view, it shows the lack of consensus within the central bank and could hurt investor confidence through some negative headlines in the weeks to come:

Source: Federal Reserve, FOREX.com

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Market Reaction

Borrowing from Prince, this is what it sounds like when hawks cry. The US dollar has predictably weakened in response to the Fed’s decision, with EUR/USD rallying above 1.14 and USD/JPY dipping below 120.00. Meanwhile, US equities dipped, then spiked before trading lower in volatile intraday trade. Bonds were the big winner, with yields on the benchmark 10-year treasury bond falling 9bps on the day to trade at 2.21%.

Moving forward, it still sounds like the Fed favors raising interest rates this year, either in October or December. Therefore, the recent trend in favor of the US dollar could reassert itself in the coming days, while the rally in fixed income may eventually peter out, especially if inflation figures start to pick up.

Written By: Matthew Weller