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Fed makes it the first of three

The Days Ahead: Shorter trading week and Europe will be very quiet. Asian markets on watch after the trade news.

One Minute Summary: Trade issues hung over stocks again. The Fed was generally hawkish and clearly thinks “gradual” increases are on the way. So, another two this year and maybe three. Tech came under tremendous pressure. The sector was down 8% with Facebook down 14%. It’s now the cheapest it’s been since the IPO. Financials had a bad week too. Normally, they do just fine as rates increase. This time there seems to be a funding problem and overnight rates climbed sharply. This might be a result of changes to how banks fund themselves post tax reform.

We're now in a higher volatility era for equities. So far this year average volatility has been 17 and it closed at 23 on Friday. It's long term average is 18. In 2017 it was 11. That’s clearly the outlier. Our list of things to worry about now includes tech, trade and earnings in addition to the normal phase of the cycle, U.S. politics and rates.

European and Asian markets performed better than the U.S. Emerging Markets held up well despite the trade issues. The dollar weakened again. It’s down about 3% this year.  

1.     Meet the New Fed.  The Fed met for the second of its eight meetings this year and the first with Fed chair Powell leading. The Fed holds a press conference in four of those meetings, which tend to fall two weeks before the quarter end. One feature the Fed has developed in the post-crisis era is that it has given very clear forward guidance on its thinking. The idea being that markets could afford few surprises. So, it was no news that they announced a 25bp increase in the Fed Funds Rate range to 1.50%-1.75% from 1.25%-1.50%.

But what the market was hanging on to was the “dot plots” and economic projections. And answers to the big questions: does the Fed see the economy growing, is there inflation and will there be more rate increases? Well, the short answers are “a bit”, “not really” and “possibly”. Here's the most important graph, the dot plot, which shows where the FOMC thinks rates should be in coming years.

A couple of things jump out:

1.     The wide dispersion of views. In just a few months, the range for rates in 2019 jumped from 1.2% to 3.5% to 1.5% to 3.8%. There was an even broader dispersion for 2020. Clearly the board thinks the tax cuts and stimulus are going to work and will need correcting.

2.     The Longer Run. The Fed sees the cycle peaking in the next two years and sees the long term Fed Funds Rate at near 3%. This seems wishful thinking to us. The economy would have to show a growth or inflation spurt that’s been absent for a year.

There is a dot for each member of the FOMC and the regional Governors. But one declined to vote and there are four Fed Board Governors still to be confirmed. And, to us, that's important. This Fed is woefully understaffed right now and new members could easily change the Fed’s outlook and hawkishness.

Other standout points were that the Fed acknowledged growth had slowed in the first quarter (so, points to the doves) but that the economic outlook “has strengthened”. They also saw inflation as benign and, in the Q&A, as far as bubbles go:

“So, in some areas, asset prices are elevated relative to their longer-run historical norms. You can think of some equity prices. You can think of commercial real estate prices in certain markets. But we don't see it in housing, which is key. And so, overall, if you put all of that into a pie, what you have is moderate vulnerabilities in our view.”

Which is good.

The takeaway is that this is benign for the markets and we saw 10-Year Treasuries rally after the meeting. We don't see this Fed as wanting to raise rates dramatically and so hold to our view that rates will stay in the 2.75% to 3.00% range for a while.

2.     More on Trade: The latest round of trade tariffs hung over the market. While we’re not sanguine about the whole trade war talk, the latest news on the steel tariffs is better. Remember just two weeks ago? It was a full on/bring it on global 25% tariff on all steel. Now, there are reprieves and exemptions on six of the ten top steel importing counties, and 28 members of the EU. That’s 56% of the total imports or around $5.2bn of additional annual costs. Of course, that’s now. It will change.

 So it may be the same with China. Rattle the sabre, invite retaliation, wait for other industries to lobby, wait some more and quietly climb down. Of course, China is a bigger game than steel:

The U.S. exports around $185bn of goods and services to China. It imports round $523bn. That blue bar is the monthly deficit in goods and that’s what the Administration has in its sights. It's around $35bn a month and was $375bn in 2017. Again, there was some pretty fierce talk about the theft of American prosperity and they targeted around $50bn of that $375bn. It’s not the whole amount. It’s tariffs of 25% on about $50bn, so $12.5bn of costs. Still, China came out swinging and will probably target Republican sensitive districts. They've already started with food products, wine and some steel but those were in retaliation for the steel tariffs, not the latest ones.

No wonder the likes of Apple, Microsoft, Starbucks, GM and Nike are in the firing line and will probably remain so. If we just do the math, the two announcement amount to around $19bn. That’s 0.1% of GDP. But the fall in stocks has been more like $1 trillion.

Bottom Line: Short week. We're looking at how Asian markets react to the escalation in the trade tariffs. As clients know, we’re placing some protection U.S. stocks right now as we expect volatility to remain high.

  Please check out our 119 Years of the Dow chart  

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John Bolton at Yale

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