Stocks rise on “dovishness” from the Fed. The S&P adds 1.2% to 2,099 and the Dow adds 1.27% to 18,076. Although the Fed removes the term “patient” from forward guidance, Janet Yellen and the FOMC will wait for further economic growth before raising interest rates. Following the meeting, the 10 year yield falls 14 basis points to 1.92% and the U.S. dollar index falls 1.6% as gold gains. The median estimate on the “dot plot” for the fed funds rate at the end of 2015 fell to .625% from 1.125% which signals that rate hikes will be slow once they do occur.
The Fed drops the word “patient” from its forward guidance, however Janet Yellen maintains that rates will not rise once the Fed is reasonably confident that inflation will head back to the 2% target. In addition, the Fed reduces projections for growth and inflation and says that interest rate hikes will be shallow once they do start. The central bank will be cautious due to the effects of the dollar strength on exports and inflation. Following these announcements, equities rise and the dollar weakens as traders expect the Fed to remain relatively dovish. The FOMC is looking for additional improvement, which means that the current level of the economy and labor market will not warrant monetary tightening. Following these announcements, the market for Fed funds futures reflects only an 11% chance for hikes in June, 39% for September (down from 55%). The market for Eurodollar futures reflects interest rates reaching a peak of 1.93% by the end of 2018.
The strong demand for long-dated international government bonds reflects a negative outlook for the future. Typically, long-dated bonds are more sensitive to shifts in baseline interest rates. When interest rates rise, yields on the back end of the curve rise more than those on the front end of the curve. However right now this trend is being reversed, with yields for longer maturity bonds falling. Yields on long-term bonds reflect expectations for the economy and inflation, and the current levels project low inflation, low growth, and zero interest rates in the future. These low rates provide investors with little protection incase inflation and rates do pick up. Another explanation is that unorthodox central bank action around the world has distorted markets and comparing current levels with historic trends may not be a good comparison.
Despite concerns by some, the junk bond market has been resilient this year amid plunging oil prices and ahead of interest rate hikes. In the beginning of the year some analysts called for turmoil and a potential selloff in high yield bonds, however markets have been resistant as total returns have been positive and companies have continued to issue high yield bonds. At the end of 2014, investors feared that potential defaults in the energy sector and global economic uncertainty would have a negative impact on junk bonds. Even when the Fed begins monetary tightening, the high yield market may find support from international investors seeking yield.