How to Interpret Fed-speak

How to Interpret Fed-speak

Summary:

  • The Beige Book is a great resource for investors looking for macro themes and insight into the Fed’s anecdotal inputs.
  • The Fed has discussed implementing a “caps” strategy in order to reduce securities holdings.
  • Short term traders might also be interested in the Fed Minutes for a specific trading opportunity.

Everyone knows the Fed is data dependent, it’s a famous phrase used in all of their statements. “The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data,” as the Fed put it in their latest release1. But what should investors exactly look at when deciphering the Fed?

Just like how technical traders base their decisions off a particular oscillator or how a fundamental investor gets an edge by following a particular section of an earnings release, the Federal Open Market Committee (FOMC) and market participants alike, digest numerous data points and anecdotes to paint a mosaic of the US economy and craft policy accordingly. Generally speaking, this comes from the 12 FOMC members, which is structured as follows: seven board governors, the President of the Federal Reserve Bank of New York, and four other reserve bank presidents. All FOMC members present their case on economic conditions. Moreover, non-voting reserve bank presidents also voice their opinion. Some of the variables these officials take into consideration can be found in two key releases.

Many investors are already aware of these releases, but glance over them. Just about any economic calendar has these events highlighted, but lack mainstream in-depth following. The content of these reports doesn’t always move the market as much as an FOMC Meeting Announcement, energy inventory, or GDP print, however, the detail enclosed can provide investors insight into perhaps the next macro move.

The Beige Book

From a high level, the Fed’s Beige Book is a “summary of commentary on current economic conditions” across all twelve Fed districts. The summary of economic activity covers an array of areas from employment and wages, to prices, manufacturing, banking and finance. The goal of the Beige Book is to gain insight into businesses and community organizations in order to best analyze and prepare for future monetary policy moves.

This anecdotal info is used in addition to traditional data analysis. Investors are able to extract valuable insight from these notes in order to position themselves accordingly. A prime example of this, “lower crop prices put further stress on the agricultural sector” from the Chicago Fed could verify a thesis in the fertilizer or soft commodity sector. Or a “tight labor market” in San Francisco could imply that the city’s largest employers like Wells Fargo, Uber, and Salesforce are expanding their operations, because according to the San Francisco Center for Economic Development those firms are the largest employers2.

Outside of specific districts, macroeconomic insight can also be extracted from the Beige Book, which is key for understanding Fed decisions. The Fed’s dual mandate seems to be close to being achieved according to the report. The widely-reported unemployment goal of 4.5% to 5.0% has already been reached with May of 2017 coming in at 4.3%, according to the Bureau of Labor Statistics. To that point, the Beige Book observed employment expanding with “businesses generally expect[ing] labor demand to increase.” 3 On the other side of the dual mandate, the Fed also noted the price of labor is expected to increase. As measured by the Fed’s preferred index, the Personal Consumption Expenditures Excluding Food and Energy – Core PCE – prices are near target per the May 2017 update. Year-over-year prices for the March period moved up 1.56%, close to the 2% target4.

The next Beige book is set to be released July 12, 2017.

Fed Minutes

Interestingly enough, in the most recent Fed Minutes, members of the board noted this exact pop in core PCE, saying specifically it was due to a “rebound in spending on energy services which had been held down by unseasonably warm weather through February, as well as an increase in outlays for a variety of consumer goods.”

Broadly, the Fed Minutes are simply notes from the latest FOMC meeting. To that point, investors can extract what the committee was focusing on during the last meeting. For example, in the latest minutes the committee gave early insight into how they plan to reduce their $4 trillion-dollar balance sheet. The method the committee suggested was a monthly series of caps on the amount reinvested from these assets. As the caps gradually increase every three months, reinvestments therefore would decline. The monetary policy team agreed that barring any material dip in the economy, or black swan event, investors should expect the Fed to start to reduce its securities holdings this year.

Economic trends tend to be reserved for long term investors, however, short term traders will also be interested in the minutes, but only for a few precise words.

Market participants have their eyes peeled for specific language on valuations. Astute traders will recall the FOMC minutes released on April 5th at 2:00 PM EST for the Fed meeting held on March 14–15, 2017.  Within the notes, policy makers viewed “equity prices as quite high relative to standard valuation measures.” As traders digested the commentary, stock prices tumbled 1.0% and 1.2% as measured by the SPX and NDX.

Source: Interactive Brokers LLC

It is a rare occurrence for the Fed to comment on stock valuations. The latest minutes didn’t have any commentary regarding valuations, but going forward, traders should keep an eye out for skeptical valuation anecdotes in the minutes; as they might foreshadow a short-term pullback. The next FOMC decision is penciled in for June 14th and the minutes will be released July 5th.

What this all means

Outside of the Fed’s objectives and valuation commentary, the minutes also note topics the committee discussed. The Fed member’s economic outlook, policy actions, and notes on the market were all discussed, but what else can be actionable for investors?

Look no further than the FX market for what to trade off the Fed. The latest Fed Minutes highlighted that inflation is a major concern for some Fed members.  While some members of the committee took the other side of this concern, noting the lackluster inflation data thus far, the market took their warning.

After a slight kneejerk reaction, taking gold futures down a few bps, investors bought up long deltas in the yellow metal thereafter, rallying the price 2% after the meeting. For investors that are keen on the charts, gold seems to be at an inflection point over the long run too. The gold ETF (GLD) is bumping its head up against a descending trend line originating from the metal’s high back in September of 2011. Connecting the series of lower highs, gold could be poised for a technical breakout should the price pop above the trend, in addition to fundamental factors buoying the price. 

Source: Interactive Brokers LLC

Elsewhere in the investment universe, there are sector ETFs that are also reactionary. Considering the Fed is dealing with slow GDP growth, expanding at 1.2% annualized in the first quarter of 2017, there are strategies to try and capitalize on what is working. Within the Beige Book, the Fed noted “residential construction growth accelerated.” The Fed minutes also noted strength in the housing market…“residential investment increased at a brisk pace in the first quarter. Starts for both new single-family homes and multifamily units moved up.” Considering the strong housing commentary, there is surely an investment thesis portfolio managers can start to build. The best performing iShares domestic sector ETFs is the US Home Construction ETF (ITB), up just over 16.84% YTD. Especially outperforming the market, considering S&P 500 PR (SPX) is only up 8.81% YTD.

Conclusion

Irrespective of one’s time horizon, the Beige Book and Fed Minutes are excellent resources for investors who are trying to understand the reasoning behind the Fed’s decisions. The quantitative and qualitative data represented in these reports can support or springboard an investment thesis across asset classes.

Outside of the Fed, other central banks publish similar reports. For investors that don’t suffer from home bias, the European Central Bank (ECB) publishes “Monetary Policy Accounts” – which covers Europe’s financial and economic conditions. The ECB’s next monetary policy account is expected to be released on July 6, 2017.

In some respects, the Fed is both near and far away from its goals, but as stated in the reports, the committee will stay vigilant in analyzing incoming data ranging from inflation to employment statistics. In response to lackluster growth and weaker than expected inflation data, the Fed is remaining accommodative, but has laid out a roadmap for future tightening.

References

1 Federal Reserve Press Release, 03 May. 2017.

2 San Francisco Center for Economic Development. “Largest Employers in San Francisco.” 2016.

3 Board of Governors of the Federal Reserve System. Beige Book. April & May 2017.

4 FRED Economic Data. Personal Consumption Expenditures Excluding Food and Energy (CPI).

 

Elite Wealth Management Team

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.  For a complete list of recommendations made within at least the past year, please contact us at (425) 828-4300 or info@elitewm.com.  Please Note: it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

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