Stocks rise following the Fed’s statement. The S&P500 and the Dow both increase 0.7% to 2,108 and 17,751 respectively. Following the Fed’s statement which appears to be indicative of a rate rise on the near end of expectations, Treasury yields and the dollar index both rise. The two year yield rises 1 basis point to 0.70% while the dollar index rises 0.7% to 97.17. The Fed statement cited “solid” job gains, “moderate” expansion, and risks that were “nearly balanced.” Yellen reiterated that before rates rise she wants to see some further improvement to the labor market and be reasonably confident that inflation was moving towards 2%. Fed watchers took special note of the addition of the word “some” to guidance, and it is being seen as a sign that tightening is getting closer. This makes the July employment report even more important.
The Fed is on track to raise interest rates this year. Yellen left her options open, as she and the FOMC are still gauging the strength of the US economic recovery. She included on job gains, economic expansion, and risks to her outlook. The FOMC dropped the statement regarding stabilizing energy prices as oil markets have sold off since the last FOMC meeting. As expected, the guidance still includes no clear reference to the exact timing for monetary tightening. Markets are expecting a liftoff as soon as September. Two jobs reports are due before then, and wage/ price data will also be closely analyzed. Headwinds to inflation continue to be falling commodity prices and the strong dollar.
The market for US Treasuries is becoming increasingly illiquid. With $12.6tn in Treasuries outstanding, only $500bn is traded daily. Market participants and regulators are concerned of a repeat of this past October when yields swung widely in just one day without explanation. There is an expectation that bond funds will experiencee heavy outflows when interest rates pick up, and funds may be further affected by illiquid markets. The head of trading and liquidity strategies at BlackRock expects discontinuous pricing with banks being unable to quote prices at some points. There is a possibility that asset managers may have to sell underlying assets to their funds at extremely discounted prices if investors seek redemptions. This would lead to great illiquidity and a sharp yield spike. Funds hold Treasuries as a safeguard for this event, however this strategy may not work if Treasuries also become illiquid. This trend is a function of how banks incentives to support markets have been reduced by regulation.
US Treasury secretary Jack Lew voices his concerns over Puerto Rico. He believes that the Puerto Rico crisis has potential to be detrimental to the US if it is not resolved in an orderly manner. He encourages Congress to take action in a letter to Orrin Hatch (a Republican senator) asking Congress to amend bankruptcy laws. This would help Puerto Rico restructure in US bankruptcy courts. Lew cites the potential for US investors to be hurt as Purto Rico’s debt is held by many US retirees. Puerto Rico has no access to the bankruptcy court under current laws as it is a commonwealth as opposed to a state, city, or municipality. Lew says that allowing access to bankruptcy court is not a bailout and should not be considered federal financial assistance. Puerto Rico currently has $72bn in debt outstanding, which has been deemed unpayable by the government. A $58MM payment is due on August 1st. The appropriate funds were supposed to be transferred to a trustee fifteen days ahead of the payment, which has not been done yet.