The Federal Reserve did just what Wall Street wanted and expected on Wednesday: It kept its key interest rate steady and decided to wait at least a couple of months before starting to scale back its $4.5 trillion balance sheet. It's a signal from policymakers that they aren't overly concerned about equity prices even as the major averages hit fresh all-time highs.
XFed policymakers had already signaled that they wouldn't hike the overnight lending rate for the third time this year as they wait for a clearer picture on the inflation outlook. The only real question was whether the Fed would announce a change in reinvestment policy — letting its asset portfolio gradually run off as mortgage and Treasury bonds mature — or would wait until the September 19-20 meeting. The Fed's statement that the change would happen "relatively soon" essentially locked in September.
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The Nasdaq composite, S&P 500 index and Dow Jones industrial average all hit record highs Wednesday morning but then backed off. The S&P 500 index, essentially flat heading into the Fed announcement, closed that way. The Nasdaq climbed nearly 0.2%. The Dow industrials led with a 0.45% gain, but Boeing (BA) accounted for all of that advance and more.
On the margins, a quicker implementation of the reinvestment shift would likely be positive for bank stocks like Bank of America (BAC), Morgan Stanley (MS), Citigroup (C) and Dow component JPMorgan Chase (JPM), which until the past few days had mostly been sidelined in the latest phase of the stock market rally amid dovish signals from the Fed.
After the Fed announcement, JPMorgan, Morgan Stanley and Bank of America slightly extended losses, all closing about 1%. JPMorgan and Morgan Stanley are still in buy range from recent breakouts. BofA was modestly below a cup-with-handle buy point at 25.22. Citigroup, which offered upbeat guidance on Tuesday, climbed back near its recent seven-year high.
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Shifting reinvestment policy this month would have sent some not-so-welcome signals to investors. One signal would have been that Fed committee members may be getting a bit nervous about equity and other asset values. It also would underscored that the hawks aren't convinced by the recent muted inflation data and want to maintain flexibility to raise rates again before December, when market pricing suggests the next hike will come.
Conversely, holding off on the change until September suggests that policymakers aren't particularly concerned about equity valuations, even amid another leg upward for the stock market.
A Bloomberg survey of Fed watchers gave just 13% odds of a reinvestment change on July 26, though most observers were expecting it to happen at the next meeting.
Economists see a gradual move away from the Fed's current stance of reinvesting all principal from maturing bonds as likely to put upward pressure on long-term interest rates. Goldman Sachs figures the shift could raise the 10-year Treasury yield by 20 basis points over time. That would contribute to an upward sloping yield curve, a positive for banks' net interest margins.
Recently, the dollar has dived to its lowest level in more than a year, partly on expectations of a more patient Fed. The weaker greenback is a boon to the earnings of U.S. multinationals such as Dow components Apple (AAPL), Boeing, Microsoft (MSFT) and Wal-Mart (WMT), helping to support the current rally. The dollar slid vs. other major currencies following the Fed statement, while the 10-year Treasury yield fell.
Fed chief Janet Yellen's July 12 testimony to Congress, along with a speech by leading Fed dove Lael Brainard the prior day, helped spark the current stock rally. Yellen made clear that the softening in inflation since March had "made it difficult to form a consensus view" on near-term interest-rate policy, wrote Ward McCarthy, Jefferies chief financial economist.
For now, Yellen will be content to watch the data for clearer evidence that inflation is on the rise because the Fed can begin scaling back its balance sheet in the interim. While the initial reductions will be quite modest, up to $10 billion per month, the Fed members have signaled that they want to have a window to implement the change while holding rates steady to avoid any market turbulence. Fed Gov. Brainard offered an even more dovish outlook for policy, insisting that rate hikes must pause, but allowing that a reinvestment shift was warranted.
The Fed's policy announcement comes a day after President Trump told the Wall Street Journal that he could reappoint Yellen to another term as Fed chief, but that he's also considering economic adviser Gary Cohn.
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