Updated: 08-18-2017

The word is out from the Federal Open Market Committee (FOMC) and the word is this: the Committee, in a unanimous decision, decided to leave the target range for the fed funds rate unchanged at 1.00% to 1.25%.

As far as the stock market is concerned, there was virtually zero surprise in that decision. Where the surprise was planted in the policy directive was in the contention that the Committee expects to begin implementing its balance sheet normalization program "relatively soon," provided the economy evolves broadly as anticipated.

We have put the phrase above in quotes because it is the hint from the FOMC that its September meeting will likely mark the start date for curtailing the reinvestment of proceeds from maturing securities. In its June directive, the FOMC said only that it expected to begin that process this year.

Of course, September is "this year," so one could make an argument that there isn't any real difference here, yet such an argument would expose some naivete in how the Fed's communication policy works.

The FOMC changed the phrasing on purpose, mindful that pre-meeting chatter in the market highlighted a growing belief that the Fed would take the occasion of this meeting to offer a hint on when it was looking to start the process of normalizing its balance sheet.

The Fed's read of the market will likely avail itself in the minutes for the July meeting when they are released on August 16.

The stock market's initial response to the directive has been muted, which is understandable for a few reasons: (1) it wasn't a real surprise and (2) it reinforced the belief following Fed Chair Yellen's semiannual monetary policy report that there isn't going to be another quick adjustment in the policy rate, as it seems unlikely at this juncture that the Fed would raise the target range for the fed funds rate in September and start the process of normalizing its balance sheet.

The latter consideration helps explain the trading dynamic as well in the dollar and the Treasury market following the release of the directive.

Specifically, the dollar weakened as traders moved on the assumption that there won't be a rate hike at the September meeting. That assumption, in turn, drove some buying interest at the front end of the yield curve.

The buying interest at the back end of the yield curve, however, seemed counter-intuitive since more supply ostensibly would be seen in longer-dated maturities when the Fed scales back its reinvestment. The thinking there, however, could be tied to an expectation that inflation should be tempered by a rise in market rates associated with the balance sheet normalization program.

Whatever the case may be, we suspect some short-covering activity driven by the seemingly counter-intuitive move aided the gains at the back end.

The trading dynamics are subject to change -- and will likely change -- between now and the September FOMC meeting. Inflation data will be a major driver in that respect, but based on the initial response to the July directive, it seems that the Fed is going to have quite the challenge on its hands to keep all the capital markets behaving normally as it embarks on the balance sheet normalization process.

--Patrick J. O'Hare, Briefing.com

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