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Reflation Pause- Part 2, October 11, 2017

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Reflation Update Part 2—Why This Reflation Is Different

In Wednesday’s Report, we covered why the reflation trade that started again in early September has taken a pause, and the reasons are twofold.

First, the market is unclear about who the next Fed chair will be. If it’s Kevin Warsh, that will be a “hawkish” surprise and rates could rise too quickly to keep this reflation “virtuous.”

Second, it’s unclear if upcoming central bank meetings, which means primarily the ECB but secondarily the Bank of England, will be Goldilocks. If either bank is more hawkish than the market expects it could send global rates sharply higher, causing a
pullback in the broad market.

Conversely, if either bank expresses doubts about growth or inflation, it could undercut the whole reflation idea that’s propelled stocks higher.

Point being, there are some key events that need to be resolved before the reflation trade can move higher. And, frankly, that makes this 2017 version of the reflation trade unique compared to previous economic reflations, most recently from ‘03-’06.

For simplicity, the easiest analogy to describe a normal reflation trade is a beach ball. When a recession occurs, the beach ball (the economy) deflates. But, low interest rates and government stimulus act as an air pump, and eventually the beach ball (economy) reflates.

Accelerating economic growth and rising inflation (due to easy money) are the “air” that inflates our economic beach ball. From a market standpoint, economic reflations are usually wonderful things. Markets go up in concert, and the way to outperform is to add beta and be exposed to cyclical, growth-oriented sectors. During a normal reflation (the last one was in ’03-’06) everything goes up regardless of what else is going on in the world.

However, this reflation is different.

Eight years after the end of the financial crisis, our economic beach ball is only half full. That’s because we’ve pumped in the “air” of accelerating economic growth (GDP going from negative to 2.5%ish) but we haven’t pumped any “air” of inflation in, yet.

Despite that, stocks are at all-time highs. Valuations are as stretched as any of us have seen them in decades. And, now we’re very late in the typical economic cycle.

Given that, barring some big surprise on tax cuts or infrastructure spending, it’s unlikely that we’re going to see a material acceleration of economic growth. In reality, 3.5% – 4% GDP growth is quasi impossible given demographics in this country—specifically the large demographic of baby boomers entering retirement, and them being replaced by a smaller workforce.

Getting back to our beach ball analogy, if inflation finally accelerates there will be a shorter time of euphoria—as the other half of our beach ball inflates. We got a hint of that in September.

But given valuations, stock prices and economic growth all are at or nearing reasonable ceilings, the risk is that after a short bit, the “air” from rising inflation over inflates our economic beach ball, and a bubble (or multiple bubbles) develop and we burst the ball. Practically, what I’m talking about is the Fed hiking rates and inverting the yield curve, which would be our signal that the beginning of the end of this eight-year expansion is now upon us.

From an advisor or investor standpoint, this creates a difficult set up. For now, we must continue to be invested and, potentially, allocate to the reflation sectors. Yet we also must do so knowing that unlike most revelations, we’re not going to enjoy an easy rally that lasts years.

So, the now years-long game of market musical chairs continues, albeit with a potentially reflation accelerating the pace of the music. For shorter or more tactical investors, holding “Reflation Basket” allocations makes sense as we approach and navigate these upcoming events.

For longer-term investors, we continue to await confirmation from the 10-year yield that this reflation truly is upon us. A few closes above the 2.40% level will be the signal, in our opinion, to rotate out of defensive names and into part or all of our Reflation Basket—Banks (KRE/KBE/EUFN), industrials (XLI), small caps (IWM) and inverse bond funds (TBT/TBF).

Bottom line, at this point in the economic cycle, for stocks to move materially higher we need inflation to accelerate and cause that reflation trade, but weneed to realize that brings us one step closer to the ultimate “bursting” of the recovery. This market remains more dangerous over the medium/longer term than the low VIX would imply.

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Reflation Pause, October 20, 2017

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Why Is the Reflation Rebound Pausing? Because It Should. Here’s Why…

After surging basically from Sept. 11 through Friday’s jobs report, the reflation rebound has taken a pause for the last few days, and I wanted to provide a comprehensive update of:

1) Where we are in the reflation process and specifically the key catalysts that are looming in the near future and that are causing this pause, and

2) Explain why this reflation trade is different from others, and requires A) A more tactical allocation to get the outperformance we all want, and B) Greater patience on the part of longer-term investors before abandoning what’s worked so well in 2017 and allocating to more reflation-oriented sectors.

Due to space constraints, I’m going to break this up into two parts covered today and tomorrow.

Reflation Update Part 1: Where Are We, and What Will Decide Whether It’s Going to Continue?

We’ve been saying since the July Fed meeting that inflation was now the most important economic statistic, and that markets needed inflation to start to rise to help fuel a “reflation rebound.”

Well, during the week between Sept. 11 and Sept. 15, Chinese, British and US CPIs beat expectations, and combined with an uptick in global economic activity, caused tactical investors to rotate into tactical sectors (banks, energy, industrials, small caps, inverse bond funds).

And, we were early on identifying that switch, and our “Reflation Basket” has outperformed the markets since we re-iterated it for short- and medium-term investors in the Sept. 21 Report.

However, also in that Report we cautioned longer-term and less-agile investors to wait for clear confirmation that the reflation rebound had started, and we identified two keys. The first was the KBW Bank Index closing above 100. This occurred both Monday and Tuesday. The second was the 10-year yield breaking above 2.40%.This has yet to happened.

So, while much of the mainstream financial press is now pumping the reflation trade (a month after it started) we’re acknowledging that it’s paused. Practically, that means we’re holding (not adding to) our “Reflation Basket” of KRE/KBE/IWM/EUFN/XLI/TBT/TBF, and think shorter-term/tactical investors should too.

I say that because I believe the first stage of this reflation trade is now complete, and in the next three weeks we will see two key events that will decide whether this reflation extends into November, pauses longer or potentially back tracks.

Near-Term Reflation Catalyst #1: ECB Meeting. Thursday, Oct. 26. Why it’s Important: As we’ve covered, markets have enjoyed a “virtuous” reflation recently because 1) Economic data has been good, but 2) Not so good that it’s causing global central banks to hike rates faster than expected.

Markets have a general expectation of what ECB tapering of QE will look like (somewhere around 20B per month) but we’ll get the details at this October ECB meeting.

If the ECB is more hawkish than expected, that could potentially send yields too high, too fast, and kill the
“virtuous” reflation. If that happened, banks and inverse bond ETFs would rally, but everything else would fall.

Conversely, if the ECB is too dovish, then markets might lose confidence in the reflation itself, and that would become a headwind.

Bottom line, the ECB needs to release a taper schedule that implies confidence in the economy and inflation, but that also isn’t so aggressive it kills the “virtuous” reflation rally.

Near-Term Reflation Catalyst #2: Fed Chair Decision.
The fact that President Trump will name a potentially new Fed chair in the next two weeks has been somewhat lost amidst the never-ending (and seemingly everescalating) Washington drama.

Right now, it’s widely believed there are three front runners: Kevin Warsh, Jerome Powell and Janet Yellen.

If Yellen is reappointed (and that’s seeming increasingly unlikely) then clearly that won’t cause any ripples in the reflation trade, and we can go back to watching inflation and yields. However, if one of the other two are appointed, things get interesting.

Warsh is considered the biggest “hawk” of the group,and if he becomes Fed chair we may see yields rise sharply, potentially endangering the “virtuous” reflation.

Powell is viewed as in the middle of the other two—not as dovish as Yellen, but not as hawkish as Warsh. But, it’s reasonable to assume that a Powell appointment would put at least some mild upward pressure on Treasury yields. It likely wouldn’t be enough to spur a killing of the “virtuous” reflation, but it would be cause for a pause in the move.

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The Odd Central Bank Out, October 4, 2017

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Over the past month, we’ve seen some big policy turns at major central banks.

• At its September meeting, the Fed shrugged off low inflation and reiterated its expectation for a rate hike in December, and three hikes in 2017, a more hawkish-than-expected outcome.

• At its September meeting, the Bank of England shocked markets by stating that due to rising growth and inflation, rate hikes would likely be needed in the “relatively near term.” While it’s not certain, many in the markets think the Fed hikes rates in November.

• At its September meeting, the ECB confirmed it will announce details for the “tapering” of its QE pro-
gram, the first step to eventual rate hikes (likely in 2H ’18).

• The Bank of Canada quasi-shocked markets by hiking rates at its July and September meetings, becoming the first developed market central bank to execute consecutive rate hikes in over a decade.

• The Bank of Japan, at its recent meeting, reiterated its dovish stance and the BOJ’s Kuroda even hinted
that the bank may need to become more dovish for the Japanese economy to finally hit its 2% inflation
target.

So, which one doesn’t belong?

The BOJ is the “odd central bank out” in the global trend of less accommodation. I think that creates a potential opportunity in DXJ, the WisdomTree Japan Hedged Equity ETF. The logic behind this opportunity is simple: With global central banks become less accommodative, the yen should decline in value against its major trading partners.

On a basic level, a weakened currency and supportive central bank are still good for stock market performance.

So, if we see the yen weaken to 120 vs. the dollar and see similar declines against the euro and pound, that should be a respective tailwind on the Japanese stock market—just like it has been in the past.

Now, clearly there are risks to this trade, particularly North Korea. But barring a surprise economic or inflation slow-down in Britain, the EU or the US, the trend in rates and those currencies is higher vs. the yen. That should be positive for Japanese stocks over the medium and longer term.

Now, I realize that DXJ has run over the past month (as has everything), but the bottom line is that if dollar/yen goes from 112 to 120 (which is entirely possible if we see a “reflation” in the US) then DXJ will move substantially higher from here.

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When Will Rate Hikes Kill The Rally?

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When Will the Fed Kill the Bull Market? (Or, What is the Neutral Fed Funds Rate?)

A lot of clichés on Wall Street aren’t worth the paper they’re printed on, but one saying I have found to be  quite accurate is: Bull Markets Don’t Die From Old Age. It’s the Fed that Kills Them.

At least over the last 20 years, that has largely proven true. The general script goes like this:

First, the Fed starts raising rates because financial conditions have become too easy (this should sound familiar). In this cycle, rate hikes began in December 2015 but importantly, they are starting to accelerate.

Second, those rate hikes cause the yield curve to invert. That happens as bond investors sell short-term Treasuries and send short-term yields higher (because the Fed is raising short-term rates), and buy longer-dated Treasuries, pushing those yields lower, because investors know the rate hikes will eventually cut off economic activity. In this cycle, the yield curve hasn’t inverted yet, but the 10s—2s Treasury yield spread has fallen from over 2% in late-2014 to fresh, multi-year lows at 0.77% (as of Sept. 5).

Third, the inversion of the yield curve is a loud-and-clear “last call” on the bull market. The rally doesn’t end when the curve inverts, but it’s a clear sign that the end is much closer to the beginning. In this cycle: We are not at that inversion step yet, although we are getting uncomfortably close.

Fourth, after the curve inverts, the Fed keeps hiking rates until economic momentum is halted. During the last two economic downturns (2001/2002 and 2008/2009) the Fed was able to hike rates to 6.5% and 5.25%, respectively, before effectively killing the bull market.

But just as the Fed continues to cut rates after the economy has bottomed, it also hikes rates after economic growth has stalled (because of the lag time between rate hikes and the effect on the economy).

So, it’s reasonable to assume the actual Fed Funds rate level which caused the slowdown/bear market is at least 25 to 50 basis points below those high yields, so 6% or 6.25% in ’01/’02 and 4.75% or 5% in ’08/’09.

In this cycle, the most important question we can ask is: At what level of rates does the Fed kill the expansion and the rally? That number, which the Fed calls the “neutral” Fed Funds rate is thought to be somewhere between 2.5% and 3% this time around (at least according to Fed projections).

However, we’ve never come out of a cycle where we’ve had:
1. Four separate rounds of QE

2. The maintaining of a multi-trillion dollar balance sheet

3. Eight-plus years of basically 0% interest rates

4. Eight-plus years of sub-3% GDP growth

So, common sense would tell us that this “neutral” Fed funds rate is going to be much, much lower than it’s been in the past.

How much lower remains the critical question (2.5%? 2.0%? 1.5?)

This is really important, because if the answer is 1.5%, we’re going to hit that early next year (it likely isn’t 1.5%, but it may not be much higher).

And, what impact will balance sheet reduction have on this neutral rate?

Again, common sense would tell us that balance sheet reduction makes the neutral rate lower than in the past, because balance sheet reduction is a form of policy tightening that will go on while rates are rising (so it’s a double tightening whammy).

There are two important takeaways from this analysis.

First, while clearly the tone of this analysis is cautious, it’s important to realize that the yield curve has not inverted yet, so we haven’t heard that definitive “last call” on the rally. And, just like at an actual last call, there’s still some time and momentum left afterwards, so an inverted curve is a signal to get ready to reduce exposure, not a signal to do so that minute.

Second, on a longer-term basis, if the Fed really is serious about hiking rates, then this bull market is coming to an end, and the risk is for it happening sooner rather than later. Because the level at which rate hikes cause a slowdown and kill the bull market is likely to be much, much lower than anything we’ve seen before (unless there is a big uptick in economic activity).

That is why I said yesterday that if the Fed is serious about consistently hiking rates going forward, that the “hourglass” may have finally been flipped on the bull run. So, while hitting that “Neutral” Fed funds rate Is hopefully at least a few quarters away (unless things are way worse than we think) it’s my job to watch for these types of tectonic shifts in the market so that we’re all prepared to act when the time is right. We will be watching this closely.

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FOMC Preview and Projections plus the Wildcard to Watch, July 25, 2017

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Tomorrow’s FOMC meeting is important to markets for multiple reasons, because it will give us additional color on when the Fed will begin to reduce its balance sheet, and whether a December rate hike is still on the table.

Those revelations will be the latest catalyst for the ongoing battle between “reflation” (which means cyclical sectors like banks, industrials and small caps outperform) or “stagnation” (super-cap tech and defensive sector out-performance).

Given the latter sectors have been the key to outperforming the markets in 2017, understanding what the Fed means for these sectors is critically important. Remember, it was the Fed’s “hawkish” June statement that saw Treasury yields rise and banks and small caps outperform from June through mid-July. And, it was Yellen’s “dovish” Humphrey-Hawkins testimony that reversed the rise in yields and resulted in the two-week outperformance of super-cap tech (FDN) and defensive sectors such as utilities. So again, while not dominating the headlines, the Fed is still an important influence over the markets, just on more of a micro-economic level.

What’s Expected: No Change to Interest Rates or Balance Sheet Policy. The Fed is not expected to make any change to rates (so no hike) or begin the reduction of the balance sheet. However, and this is important, the Fed is expected to clearly signal that balance sheet reduction will begin in September by altering the fifth paragraph to state that balance sheet normalization will begin “soon” or “at the next meeting.” Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Hawkish If: The Fed Reduces the Balance Sheet. This would be a legitimate hawkish shock, as everyone expects the Fed to start balance sheet reduction in September. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Dovish If: No Hint At Balance Sheet Reduction. If the Fed leaves the language in paragraph five unchanged (and says balance sheet reduction will happen “this year”) markets will react dovishly, as balance sheet reduction likely won’t start until after September, and that means no more rate hikes in 2017. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Wild Card to Watch: Inflation Language.

So far, the Fed has been pretty dismissive regarding the undershoot of inflation, but that may change in tomorrow’s statement. If the Fed reduces its outlook on inflation (implying low inflation isn’t just temporary) or, more significantly, implies the risks are no longer “roughly balanced” (which is Fed speak for we can hike at any meeting), then a December rate hike will be off the table, and that will result in a likely significantly dovish move. If made, that change will come at the end of the second paragraph.

Bottom Line

To the casual observer, this Fed meeting might look like a non-event, but there are a lot of potential changes that could have significant implications on sector performance over the next few months. So, again, getting this Fed meeting “right” will be important from an asset allocation standpoint.

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Market Implications of Fed Vice Chair Dudley’s Optimistic Statements

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What are the market implications the optimistic statements from Fed Vice Chair (and President of the Federal Reserve Bank of New York) William Dudley’s optimistic statements this week?

Fed Vice Chair Dudley reiterated and bolstered Fed Chair Yellen’s “steady as she goes” message on rate increases last week, again dismissing low inflation as not a big enough problem to stop the Fed from continuing to hike.

Additionally, Dudley was optimistic about economic growth, saying he was “confident” the current economic expansion had plenty left in the tank.

Bottom line, Dudley reiterated that the Fed is committed to raising interest rates and removing accommodation, and that caused a mildly “hawkish” reaction across currencies and bonds.

It also helped push stocks higher (although stocks were already in rally mode). So, our general Fed outlook remains the same: Balance sheet reduction starting in September, and a rate hike in December.

However, in order for the hawkish tone from the Fed to get the Dollar Index and yields moving higher, we’ll have to see actual improvement in the economic data, and that remains elusive. As such, the market remains skeptical about future rate hikes, despite the Fed’s warnings (Fed fund futures are pricing in just a 20% chance of a September hike, and 40% chance of a December hike). So, the Fed has some work left to do on reestablishing its hawkish credibility after years of ultra-dovishness.

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Fed Takeaways: What the Hike Means for Markets, June 15, 2017

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FOMC Decision: The Fed increased the Fed Funds rate 25 basis points, as expected.

Wednesday’s Fed decision was not the dovish hike the market was expecting, although it wasn’t exactly a hawkish decision, either (even considering Yellen’s balance sheet surprise). Looking at the statement, the Fed wasn’t as dovish in its language as the consensus expected. The economic growth language remained good, and actually improved a bit from the May statement.

The inflation language, as expected, was downgraded, but the Fed refrained from changing the characterization of risks, and left them “roughly balanced.” That’s Fed speak for “any meeting is live for a rate hike.”

However, the Fed did note the undershooting of inflation recently, and explicitly said they are monitoring inflation, meaning if it continues to underperform they will react with easier policy. For now, the best way to characterize the statement is “steady as she goes,” with regard to the Fed’s current outlook.

Wildcard to Watch: Balance Sheet Reduction

We were right to make this our wildcard to watch, as the topic of the balance sheet provided the only real surprise in yesterday’s Fed meeting.

Importantly, the Fed gave guidance on all three major balance sheet related questions: When will it reduce the balance sheet? How will it reduce the balance sheet? What holdings will it reduce?

What will it reduce: The Fed revealed that it will simultaneously reduce holdings of both Treasuries and Mortgage Backed Securities, which was generally expected.

How will it reduce its balance sheet: The Fed will implement a rising monthly “cap” on principal reinvestments. What that means, practically, is the Fed will not reinvest the first $6 billion of Treasury principal and the first $4 billion of MBS principal, making it a total of $10 billion that it won’t reinvest each month, at least initially. That cap will rise by $10B every three months, so one year from the start date (which will likely be September), the Fed will no longer be reinvesting $50B worth of bond principal payments per month. That number and this escalation is not surprising, and was close to in line with most forecasts (i.e. this wasn’t “hawkish.”)

When will the Fed start Reducing the balance sheet: This was the surprise, as Fed Chair Yellen said balance sheet reduction could start “relatively soon.” That is sooner than expected, as the consensus was the Fed would hike rates again in September, and start to reduce the balance sheet in December. Now, that may be flipped.

Since reduction of the balance sheet is like the Fed hiking rates, this was taken as mildly hawkish, and the dollar bounced along with bond yields. However, this surprise is not a hawkish gamechanger, and won’t alter anyone’s outlook on Fed policy going forward.

Bottom line, for all the noise and production yesterday, the Fed outlook remains broadly the same: One more rate hike and balance sheet reduction in 2017, unless inflation metrics get much worse.

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Could The Fed Give a Hawkish Surprise Today?, June 14, 2017

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The simple answer is probably not, but there is a better chance than previous meetings because of one simple reason: Despite two rate hikes since December, in aggregate, “financial conditions” have gotten “looser” in 2017, so Fed rate hikes aren’t really working.

Financial conditions is a term that was coined (for all intents and purposes) after the financial crisis, so we could see financial conditions were getting very tight (i.e. less credit availability) and when liquidity was drying up.

Now, in a post-crisis world, multiple institutions keep “Financial Conditions Indices” that measure the level of interest rates, liquidity in the system, credit availability and other measures of whether the availability of money and credit is getting loose (i.e. more availability) or tight (less availability).

I watch three such indices: (withheld for subscribers—unlock with a free trial). All three have slightly different methodologies, but all generally try and accomplish the same objective, which is to see if financial conditions in the economy are “looser” (i.e. easier credit/more liquidity) or if they’re getting “tighter” (i.e. less credit and less liquidity).

Here’s the important takeaway: All three financial conditions indices have shown aggregate financial conditions getting looser since the start of the year. In fact, in aggregate, financial conditions have eased by the equivalent of a 25 basis point rate cut since 2017 started, despite two rate hikes.

The reasons for this are somewhat obvious: Liquidity remains ample; credit remains readily available, interest rates are down, the stock market and housing prices are up (so more ability to borrow).

From a Fed standpoint, the takeaway is this: The fact that the Fed’s “slow walk” in interest rates isn’t mopping up excess liquidity in the market may make the central bank more prone to get “hawkish,” which again would be positive for banks and cyclicals (i.e. the reflation trade), but negative for defensives and higher-yielding sectors (utilities, consumer staples, REITs).

Again, I’m not saying the Fed will be surprisingly hawkish today, but if I had to bet on a surprise based on these financial conditions indices, I’d bet hawkish over dovish (although I’m making the dangerous assumption the Fed is serious about getting rates back to normal levels).

Bigger picture, though, the takeaway here is that the Fed’s policies, so far, are not having the desired effect. And, if this continues, the Fed will have to “shock” markets with a substantial rate hike at some point if it wants to regain market related credibility—and that increases the risk of higher rates over the longer term (or, higher inflation if they don’t provide that shock).

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This Week’s Fed Decision Takeaway and Rate Hikes To Come, May 4, 2017

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The Fed made no changes to interest rates this week, as expected.

Fed Decision Takeaway

The Fed statement almost perfectly met our “Meets Expectations If” scenario, as the Fed acknowledged the slight loss of economic momentum since March, but stated it viewed the slowing as only temporary, and left the door firmly open for a rate hike in June.

Looking specifically at the statement, the Fed said yesterday that economic activity had “slowed” compared to “expanded at a moderate pace” in March. But, in the second paragraph, the Fed said the loss of economic momentum appears to be “transitory,” and signaled the recent underwhelming data won’t make the Fed deviate from future rate hikes.

Underscoring that point was the fact that the Fed said risks to the near-term economic outlook continue to be “roughly balanced,” which is Fed speak for “we can hike rates at any meeting going forward.” Bottom line, the Fed was not spooked by the recent soft data and it is not deterring them from any future rate hikes… yet.

From a market standpoint, there was a mild “hawkish” reaction, not so much because the statement was hawkish, but instead because there was nothing dovish in the statement. That’s what markets have become conditioned to expect. The Dollar Index drifted to the highs of the day 30 minutes after the statement while the 30-year Treasury erased small gains and closed fractionally lower. Stocks drifted slightly lower, but selling was mild. Overall, the Fed statement was not a market mover.

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FOMC Preview and the Next Rate Hike, May 2, 2017

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There is virtually no chance the Fed will hike rates at tomorrow’s meeting, as the chances were slim before the recently disappointing economic data. Now, those chances have declined to near zero. The key question tomorrow is: Just how forcefully will the Fed telegraph the next rate hike?

The answer to that question, taken in the important context of the recent slowing of economic momentum, will decide whether the FOMC decision pushes stocks higher, or whether we see a retracement of the recent gains.

May FOMC Meeting Preview + Next Rate Hikes

Hawkish If: The Fed clearly signals a rate hike is coming in June. Right now, Fed fund futures are pricing in about a 70% chance the Fed does hike rates, but that’s not a consensus expectation, yet. If the Fed specifically points to the “next” meeting in tomorrow’s statement (as it did in the fall of 2015 and 2016) as the likely date of the next rate increase, you will see markets react hawkishly as a June rate hike is not a foregone conclusion. Additionally, if the Fed is still intent on hiking rates in June despite recent economic data disappointments, that might imply a Fed that is more hawkish than previously expected.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Meets Expectations If: The Fed slightly downgrades the assessment of the economy in paragraphs one and two, but also says any slowing of activity is likely only temporary (it’s the temporary part that is the key). Markets expect the Fed to acknowledge the modest loss of economic momentum, but not to make too big a deal out of it.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Dovish If: The Fed materially downgrades economic commentary in paragraph one and downgrades the outlook on inflation, and in doing so materially reduces the chances for a June rate hike. Specifically, to be dovish we would need to see 1) A downgrade of both the growth and inflation language in paragraph one, plus no mention of it being temporary. The net effect would be to remove the expectation for a June rate hike.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Wildcard to Watch

Fed Balance Sheet. As we have covered, the reduction of the Fed’s balance sheet is an important but under reported topic that could result in a more-hawkish-than-anticipated Fed. Specifically, the major questions facing the Fed regarding the balance sheet are:

1) When will the Fed begin to reduce the balance sheet (2017 or 2018)?

2) What securities will the Fed stop buying (just Treasuries or Mortgage Backed Securities, too)?

3) How will the Fed stop reinvesting proceeds (all at once, or gradually)?

How these questions are answered will determine whether the Fed balance sheet is a hawkish influence on markets (yields up, stocks potentially down).

I (and almost everyone else) do not expect the Fed to touch on this in this week’s meeting. However, if the Fed does address this topic, it will come in paragraph five of the statement. Any change there will likely have hawkish implications on markets tomorrow, but again any changes are unlikely.

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