Equity markets jumped after the Federal Reserve Open Market Committee threw in the towel on interest rate increases and balance sheet reduction. The US dollar fell sharply and Chinese stock ETF’s rose with the broad market.

Mainland and Hong Kong investors will get a Chinese New Year’s bonus in the last trading sessions before the holiday break next week. Notably, the most liquid H-shares ETF, FXI, moved faster and higher than the S&P 500 after the Fed announcement:

The moral of the story is to stick with China. Any shift towards risk-friendliness appears to benefit the equity market with the highest risk-reward. A dovish Fed, to be sure, helps China, by taking pressure off the RMB as the Chinese monetary authorities ease policy. But the RMB has been rising, from just below 7 to the dollar on Oct. 31 to 6.71 today.

The Fed went further than the consensus expected, promising “patience” on future interest-rate increases as well as “flexibility” about reducing the $4 trillion balance sheet it accumulated during years of quantitative easing. The US central bank is “prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”

In plain English: Tentative steps by the Fed to raise interest rates last February and again last fall contributed to tumbles in the stock market and sharp widening of credit spreads. The Fed is afraid to blow up the equity and credit markets so it will sit there like a deer in the headlights for the indefinite future.

The Fed is worried about deflation risk, for a good reason: the level of asset prices, including equities, commodities, and real estate, has risen on a tide of unlimited cheap credit thanks to $12 trillion of balance sheet expansion by central banks around the world. Any attempt to let air out of the bubble threatens to pop it.

There is one big macro risk in the market, namely the possibility that central banks will shift to quantitative tightening, that is, balance sheet reductions, just as the Fed proposed to do until today. The equity market is bedeviled by dodgy valuations especially in the tech sector, which has dominated returns during the past several years. I observe that stock prices have tracked oil prices tick for tick, because both gauges are subject to the same risk.

“Common-sense risk management means patiently waiting for greater clarity” about risks arising from US-China trade negotiations, Brexit, and other “unresolved” political issues, Fed Chair Jerome Powell said at his Wednesday press conference. In case of stress “the Federal Reserve is prepared to use its full range of tools, including balance sheet policy.”

For years, the Fed’s models have predicted higher inflation due to higher employment and higher wage levels. No such thing materialized, and the Fed is terrified of the opposite of what the models forecast, namely deflation. I argued December 18 that fear of deflation would push the Fed into a dovish stance. US incomes are rising but not fast enough for many American households to buy homes.

A year ago, US home prices were rising at 6% year on year, compared to 3% today, and rents were rising at 3% year, compared to 1% today. The housing sector is the weakest in the US economy. Pending home sales in December fell 9.5% from year-earlier levels. Shelter makes up about two-fifths of the Consumer Price Index, which means that lower inflation is baked in the cake for the next twelve months. US employment growth remains strong, as I wrote January 23, but it’s overwhelmingly concentrated in small businesses and in low-wage industries, mainly healthcare and leisure/entertainment. The latest data point from the payroll processor ADP shows a gain of 213,000 jobs in January.

Housing demand remains weak, however, and that is pulling down home sale prices as well as rents. Rent and home prices along with commodity prices explain virtually all the variation in the Consumer Price Index. The chart below shows the market’s measure of expected future inflation (the difference between the yields on ordinary Treasuries and inflation-indexed Treasuries) and the Goldman Sachs-S&P Commodity Index (monthly data for the past five years). There’s clearly a relationship, but it’s unstable.

If we add home prices and the cost of rent to the mix, we obtain a very tight forecast of the Consumer Price Index, as in the chart below (again, monthly observations for the past five years).

The point of the exercise is that the Fed is boxed in by falling inflation. Fed Chair Powell said that the one thing that would prompt him to tighten monetary policy faster is inflation. For 2019, disinflation is already in the pipeline.