Wednesday April 27

Stocks rise as the FOMC statement was interpreted as dovish. The S&P 500 rose 0.2% to 2,095 and the Dow Jones gained 0.3% to 18,041 rising back above the 18,000 threshold. Stocks initially fell after Apple’s earnings miss pulled down indices. Apple shares down 6.4% on the day, and tech industry shares were down 1.3%. However stocks rebounded after the FOMC statement. The Fed kept rates unchanged as expected, and it suggested that previous concerns of a US economic slowdown had diminished somewhat. The market for Fed funds futures now reflects a 50% probability of a 25bp hike before September. Stocks also benefitted from higher oil prices. Brent crude oil rose nearly 3% to $47.06 and WTI gained 2.9% to $45.33. Yields fell in the US, Germany and the UK. The US Treasury yield fell, breaking eight days of rising yields. The ten year yield fell 7 basis points to 1.86% after the dovish Fed statement. The BoJ is expected to expand monetary easing through higher asset purchases and further negative rates when it meets tomorrow. The yen was flat on the day at Y111.31.

The Fed continued its cautious stance with regards to the future trajectory of interest rates. The Fed reiterated concerns regarding the global economy and low inflation. The next FOMC statement will be released on June 15, and the Fed left open the possibility for a rate hike at that date. If economic data over the next two months proves to be strong, the international economy holds up, and the Brexit in June appears unlikely the Fed may take action at the next meeting. Dennis Lockhart of the Fed has previously indicated that the potential outcome of the Brexit might have an impact on the Fed’s decision given the high degree of uncertainty that it would cause. Robert Kaplan of the Dallas Fed echoed a similar sentiment. A statement from the prior FOMC statement regarding the risks from abroad was removed from today’s outlook. The chance of a June rate increase is now just 15% compared to a 1.2% chance yesterday. Currently financial markets have stabilized, the labor market continues to be strong, and global risks are somewhat subsiding. However US growth is expected to have been slow in the first quarter. In February the PCE rose just 1%. The Fed will weigh the growth outlook along with the inflation outlook heavily in June.

Inflation expectations appear to be underpriced in financial markets. At the peak of the recession concerns at the start of the year the ten year breakeven rate was just 1.2%. Even as the financial markets rebounded and the outlook now is much more optimistic than it was at the start of the year, that expectation has risen to just 1.6%.The breakeven rate has been declining steadily over the last four years but has rebounded only slightly in recent months as the outlook improved. With inflation currently around 1% and on a rising trend, it appears that these expectations are on the verge of shifting. The Fed continues to target 2% inflation over the medium term. The Fed has also indicated that it is willing to let inflation run a little on the high end just to be safe with regards to the pace of rate hikes. TIPS would outperform in the event that inflation starts to materialize. The softer dollar, and higher commodity prices are both conducive to higher inflation. The tightening labor market too will also put upward pressure on inflation as wages start to rise. Secondary indicators of wage pressure such as the layoff rate, the number of employees quitting jobs, employers finding jobs difficult to fill, and percent of workers earning minimum wage all indicate that wages are set to rise.

Santander is set to reduce its presence in the subprime auto lending market. The market has been heating up over the last few years and credit risk has been on the rise. By reducing its presence Santander is indicating that it is willing to let competitors take on market share in addition to more risk. Demand for auto loans has been driven by low commodity prices, falling unemployment, and low interest rates. As a result outstanding loans last year reached $1tn which is almost 50% higher than 2010. At the same time very risky borrowers have been able to get access to credit, reminiscent of the 2008 real estate crisis. Loan to value ratios and debt to income ratios in this space have both risen. Santander is the largest lender in this industry, and shares have fallen as the market has become more aware of these risks. Stock prices rose after this announcement.

Wednesday April 27

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