Wave of Sorrow: Will the Horrors in Paris Keep the Fed on Hold?
Key Points
- With heavy hearts, we consider the implications of the terrorist attacks in Paris.
- So far, the needle has moved only slightly on Fed policy specific to the December FOMC meeting.
- We remain in the “Fed policy loop,” where we’ve been all year.
It’s always with a heavy heart that we, as analysts with responsibilities to our investors, attempt to divine the implications for markets of past and present terrorist attacks. The horrific events of Friday in Paris are yet again a reminder of the fragility of what we so often take for granted. Our prayers go out to all those impacted by such a senseless set of acts.
Testament to human strength and resolve is the bounce back seen in markets over the past 15 years following like acts. Although initially sharp and swift, they have also been consistently short-lived. Having collected data from Bloomberg, see below the details of the four most recent and significant terrorist incidents:
September 11, 2001: New York
- 3,000 people were killed
- US equity markets shut down until September 17
- Upon opening, S&P 500 sank 12% in five trading days (most since aftermath of 1987 crash)
- By October 11, losses were recovered
October 12, 2002: Bali
- 200 people killed in nightclub bombing
- Indonesian equities quickly sank 10%
- By November, losses were recovered
- Jakarta Stock Price Index ended year up 8.4%
March 11, 2004: Madrid
- 191 people killed in commuter train bombings
- Spain’s IBEX dropped 2.2% that day; continuing to fall through March 15
- By early April, losses were recovered
July 7, 2005: London
- 50 people killed in subway bombings
- FTSE 100 fell 1.4% that day
- By next trading day, losses were recovered
Impact on Fed policy?
Given that the Fed mentioned global stress as a reason not to hike rates at the September Federal Open Market Committee (FOMC) meeting, might the Paris attacks cause the Fed to reconsider hiking in December? The attacks led to an expected safe-haven rally in the US dollar, which acts itself to tighten monetary policy. Recall that after the extremely strong October jobs report—coupled with the more hawkish tone of the October FOMC statement—expectations for a December rate hike spiked higher. But many are now asking whether the combination of the Paris attacks and the rally in the dollar will put the Fed on hold.
It’s a question to which we don’t have an answer. The Fed and markets have been stuck in a “policy loop” as illustrated in the graphic below. BCA Research has been writing about this loop for much of this year, so I decided to create the visual for clearer understanding.
Fed Policy Loop
Source: BCA Research Inc., Charles Schwab.
The loop creates a conundrum for the Fed and markets; and we have been swirling in this loop throughout 2015:
Spring: financial conditions ease
- Weaker US dollar
- Flatter credit spreads
- Lower volatility
- Higher equities
- Steeper yield curve
- Fed commentary became more hawkish
Late-summer: financial conditions tighten
- Stronger US dollar
- Wider credit spreads
- Higher volatility
- Lower equities
- Flatter yield curve
- Fed commentary became more dovish
October: financial conditions ease
- Weaker US dollar
- Flatter credit spreads
- Lower volatility
- Higher equities
- Flatter yield curve
- Fed commentary became more hawkish
Below, I’ve included individual charts of each component of the loop, and you can see the easier (green) and tighter (red) phases.
Source: FactSet, as of November 6, 2015.
Source: FactSet, as of November 12, 2015.
Source: FactSet, as of November 13, 2015.
Source: FactSet, as of November 13, 2015.
Source: FactSet, as of November 13, 2015.
Where to from here, Fed?
This is the question to which we don’t yet have an answer. We are seeing troubling trends which could lead the Fed to punt yet again. The dollar has been strengthening, stocks have been selling off anew (with deteriorating breadth), and volatility is moving higher. So far, though, credit spreads and the yield curve are behaving.
Surprising perhaps is that expectations for a December hike have not withered more. Following the strong October jobs report, they shot up to 68% and even with the Paris attacks, they’ve only retreated to 64%. We will watch this implied probability closely over the next few weeks.
The action over the past few days has not been encouraging. As of last Thursday, both the S&P 500 and the Dow fell below their respective 200-day morning averages, with the NASDAQ following suit on Friday. The aforementioned uncertainty regarding the December Fed meeting has been a culprit—but so were softer retail sales and producer prices.
These latest trends support our “neutral” rating on US equities, which means investors should maintain normal allocations. For more trading-oriented investors, this translates to a recommendation to “trim on rips and add on dips.” The uncertainty—which has only been exacerbated by the attacks in Paris—is likely to persist, which means investors should expect more volatility in the weeks to come.
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