What's Up With Today's Paradoxical Fed Reaction?

Tough day for the casual observer to try to make sense of what happened. There's even some disagreement between the not-so-casual observers. Let's focus on what we can know for sure. The Fed didn't hike. The market was pricing a 1 in 3 chance of a hike, so the shortest end of the curve logically rallied on that. Longer term rates rallied a bit too, at first. No surprises as of 2:30pm. Warsh's prepared remarks weren't significant, and the rally remained intact. Things began to change rapidly when he suggested looking beyond PCE to a broader set of inflation data to achieve the 2% target. While that could speak to a genuine desire to improve the Fed's understanding of inflation, the market could also view it as an excuse to avoid hiking. He also suggested that there was less urgency to consider a hike because the bond market was already doing the Fed's job by moving toward higher rates. Traders could also view this as an excuse to avoid hiking. Taken together, cynical traders might even be thinking that Warsh will continue to talk tough on inflation, but also continue forcing the long end of the yield curve to do the Fed's heavy lifting. In May, we warned that the long end would quickly punish any perceived attempt to keep the short end artificially lower and today was the first day where that offered the cynics a shred of evidence. NOTE: we take no position on whether the cynics are right or wrong, but this is the most obvious way to justify an otherwise excessively paradoxical reaction--ESPECIALLY when we consider that bonds stopped selling the moment the press conference ended.