Prudent is not just a word: It is the basis of the new Fed policy.
The Fed changed its message after its March policy meeting last week ever so slightly, but meaningfully, by substituting the word "prudent" for the word "patient."
While the meaning of the policy change was ever so slight, if it amounted to a change at all, it had a significant impact on all financial markets. The dollar fell, bond markets and stock markets rallied and there was a deep sigh of relief by investors worldwide.
As we mentioned last week, the scale tilted heavily towards the Fed maintaining its overly easy monetary policy as the recent data points indicate near-term economic weakness due to the unusually harsh winter, the strength of the dollar, weakness overseas, declining commodity prices and the widening interest rate differential. No surprises here. Now that this hurdle is behind us, it's time to focus on the future and how to profit from the correct asset allocation, the correct regional exposure and the correct investments, both long and short.
If you have the time, you may consider reading two short pieces that I wrote last week. The first was titled "Survival of the Fittest" and dealt with how the well financed and companies with low cost of production, such as Exxon Mobil, Halliburton, Rio Tinto and BHP Billiton, are playing the long ball and poised to benefit from declining prices as the marginal producers are forced to sell assets and/or enter bankruptcy. This game has been played many times before. By the way, these companies have very high and well-supported dividends while you wait for the turn in commodity prices.
The second piece was titled "Look Over the Valley," which points out that weak first quarter earnings for many companies will be an aberration due to the harsh winter, a strong dollar (which hurts reported dollar earnings), dumping by foreign competition at prices beneath cash costs of production and the west coast dock strike. If opportunities to invest in strong companies with sound strategies and investor-friendly managements can be created at lower prices as a result of disappointing first quarter earnings, I'd be a buyer, as these companies’ results will improve and normalize as we move past the valley.
This was a very important week as events both here and abroad reinforced my view that we are at an inflection point for world economic activity, albeit slower than in the past, but not all that bad. In addition, many longer-term issues are being addressed in some countries that will help build a stronger foundation for future growth. I wish that I could include the United States in that list, but our federal government is too focused on politics rather than governing. Gridlock is the best that we can get for now. Sad but true.
Let's review of the past week's events and their implications for the foreseeable future in the United States. The anticipation of a change in the language of Fed policy was clearly a key event. The market declined when the word "patient" was removed in regard to maintaining monetary policy. But after "prudent" was inserted and the Fed lowered its interest rate assumptions meaningfully for both this year and next, the markets switched gears fast.
The median forecast for the Fed funds rate dropped 50 basis points to 0.625 percent for year-end 2015 and down 62.5 basis points to 1.875 percent for year-end 2016. What else did the markets have to see? The yield curve flattened, the interest rate differential narrowed, the dollar fell and the equity markets rose.
The new assumption was that the Fed would hold off until fall at the earliest to begin raising the funds rate for all the reasons that we enumerated last week. Naturally, this can change was based on future data points. The Fed is doing the right thing by remaining cautious, as it needs more proof that the economies both here and abroad are really doing better and are in recoveries that are sustainable. "Prudent" is the new key word for the Fed.