The Fed's gambit

Raise your hand if you saw that one coming.  After five months of prevarication, the Fed was as clear as it's been in a long time that not only is June still on the table, if things go as planned it's more likely than not.

Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.

Retail sales and IP are both consistent with growth picking up, and the CPI with continued progress on inflation.    That oil remains near six month highs does little to steer the message away from conditions evolving in a way consistent with a rate hike next month.  Even the Brexit polls are playing ball, as long as you're not long 2 month cable vol.

Of course, it wouldn't be the Fed if they didn't leave themselves an out.  The minutes specifically cited the Brexit vote and Chinese currency policy as potential threats to market stability.  One need only be slightly cynical to view the latter qualifier as virtually rolling out the red carpet for China to engineer another RMB wobble against the dollar (that it weakens against the basket apparently goes without saying these days).   Stay tuned.  The DXY is already looking perky- USD/JPY above 110, USD/CAD north of 1.30, and the dollar index threatening to break the levels that have constrained it for the last couple of months.

Nevertheless, they evidently put a plan in place to start banging the drum:

Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments. 

Who knew that Eric Rosengren is in fact the man behind the curtain?  In fairness to the Fed, this looks exactly like them doing what Macro Man has thought they should have been doing all along: telling the market what it wants, rather than vice versa.  In a parallel universe where ZIRP-world is only a fantasy bed-time story meant to scare young central bankers-to-be, pricing a hike for June would be a chip shot given this language.

Unfortunately, that's not the world we live in, and the prospects probably remain more tenuous than that language would suggest.   It will be very interesting, for example, to see how the Fed would react if markets were only 40% priced for a June tightening on the day of the announcement, given their historic predilection for only hiking when it's not a surprise.  If they don't want to face the challenge, then their task will be to guide markets as forcefully as they did today.   A bang-up payroll figure next month would obviously help do the job for them.  

As you can see, yesterday's minutes took the chance of  Jun tightening from virtually nil to a 1/3 chance in one shot.  Further upside should be easier to come by from here, particularly if the data is strong and/or any of the Board of Governors big shots echoes that June is looking odds-on.

What will it mean for markets?  On the face of it, it looks quite clear.   5 year yields registered a very clean break of the downtrend that has defined yields this year, putting in a higher high (to go with a prior higher low) in the process.  On a host of measures, further upside beckons for yields. 

For equities, meanwhile, the outlook is less sanguine.  Macro Man ran a little study using the third Fed funds futures contract as a proxy for imminent policy expectations.   He compared the trailing 4 week move in Fed pricing with the subsequent 4 week price change in the SPX.  As you can see, the relationship is generally quite negative (correlation of -0.62 over the last year or so) and would appear to argue for more weakness from here, yesterday's flat result notwithstanding.

Where it gets tricky, of course, is if financial conditions tighten too much (higher yields, higher dollar, weaker stocks) before the meeting.   Given that these are all a natural response from ratcheting up expectations of the policy trajectory, the next four weeks may well off punters both the thrill of victory and the agony of defeat.   What seems clear, however, is that while the Fed may have made an opening gambit, it's unlikely to proceed directly to the endgame.  For choice, though, Macro Man would expect recent moves (higher dollar, higher yields, weaker GDX and stocks) to continue a while longer before policymakers are prepared to react to the market's "counterattack."