Fed was dovish as expected. Now, to take profit

THE Federal Reserve has delayed hiking rates, but don't get too happy - there is limited upside in equities from here.

In the end, things played out as we expected, which was that the "risk rally would likely be supported by dovish Fed". Indeed, this was the continuation of the technical rebound we predicted in the last week of August, but this same rally is likely to be in its final phase.

Although the economists were evenly split on the decision, the market was clear the Fed wouldn't raise the rates this time. The Fed Funds Futures market assigned 28 per cent probability at the start of the week, and ended at 32 per cent just before the meeting. So the market has been pricing in this outcome the entire week, with stocks pushing higher, the US dollar index DXY weakening, emerging-market equities rebounding, Asian currencies enjoying some respite from decline and the AUD/USD getting a little lift within a broader downtrend.

In the end, the Federal Open Market Committee (FOMC), the Fed's policy body, erred on the side of caution for the reasons we outlined on Monday - the key ones being that inflation was way too low for comfort and that the emerging-market turmoil, particularly China's financial market and economic problems, weighed heavily on the Fed's confidence.

While it was not couched in those terms, the Fed did not want to repeat the mistake of 1997, when it hiked its policy rate while the emerging market's problems were brewing in the background, only to have to cut rates when those problems became a full blown financial crisis later that year.

What now? Traders who went tactically long on equities late last month should consider taking profit. The technical rebound is likely to run out of fuel soon. The S&P500, which rebounded from a low of 1,867, has had a decent run. It closed at 1,990 overnight. We see heavy resistance in the region of between 2,000 and 2,100 points.

The same applies for those who tactically traded long on Asian currencies, including the AUD. The limits to the relief rallies are not terribly far away.

The US economy remains in decent shape - certainly in line with our line about it being the "best-looking guy in the ugly parade". So the dollar should push back up again. Note that even with the DXY softening over the past two weeks, the 10-year US Treasury yield has been pushing higher.

Fed chairman Janet Yellen said: "Recent global, economic and financial developments are likely to put further downward pressure on inflation in the near-term. These developments may also restrain US activities somewhat."

But she noted that the outlook for the US economy was unchanged at this stage, with the labour market's recovery continuing and domestic spending appearing "sufficiently robust that an argument can be made for a rise in interest rates at this time". However, in light of the heightened uncertainties abroad and a slightly softer expected path for inflation, the FOMC decided to hold back from hiking rates, Ms Yellen said.

"The Committee continues to anticipate that the first increase in the Federal Funds rate will be appropriate when it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its 2 per cent objective over the medium-term."

"The importance of the initial increase should not be overstated. The stance of monetary policy will likely remain highly accommodative for quite some time after the initial increase in the Federal Funds rates," she said.

So what's there for equities to not like about the Fed's monetary policy remaining "highly accommodative for quite some time"? Why would stocks then sell off?

In a nutshell, zero interest rates are in the price. And that price is too high. Valuation in the US market is at a cyclical peak, while corporate earnings are at risk of declining. Never mind growth declining, index earnings are at risk of shrinking. A flushing out of valuations is needed to restore interest in the market. That is likely to occur soon.

The writer is the chief investment officer of DBS Bank