The odds that the Federal Reserve will surprise markets tomorrow with either its decision to accelerate tapering or in its Summary of Economic projections seem very low indeed:
- Chair Powell previewed the former during Congressional testimony a few weeks ago.
- Fed Funds Futures priced in a December FOMC “Dot Plot” featuring expectations of 2-3 rate increases in 2022 many months ago.
Still, there is always the possibility of a communication misstep when the Fed alters course or changes its mental models about how the world works. Think back to 1994’s sequence of 50 basis point rate increases, for example. And, from everything we read, some investors have not yet entirely forgiven Chair Powell for his 2018 flirtation with a 3 percent neutral rate of interest. He changed course when equity/corporate bond markets objected, to his credit. But … His very recent shift from saying inflation is transitory to saying it is a subject of concern does look like the action of a Fed Chair who reads the tape as much as the latest economic literature.
Long story short, we need a playbook in case things go pear shaped tomorrow and into the weekend. Four thoughts:
#1: We are working under the assumption that US equities have one more run left in them before the end of the year. Jessica’s analysis yesterday is clear enough: Santa Claus rallies are real even if St. Nick always seems to have the same handwriting as one’s parents. On top of that, Wall Street’s estimates for Q4 corporate earnings are rising again (as we noted in Sunday’s report). Lastly, Q4 GDP should be at least 5 percent and the Atlanta Fed’s GDPNow model shows no sign that growth is wavering as we wrap up the year.
#2: The one thing that could change that perspective is if the new “Dot Plot” signals a faster potential pace of monetary tightening in 2022 and 2023. The graph below is the most recent Dot Plot from September. Back then, FOMC was split about whether rate increases would be necessary in 2022 (9 members said No, 6 said one rate increase, 3 said two increases). The committee’s perspective on appropriate policy in 2023 was all over the map, but the modal guess was a total of 4 rate hikes between September 2021 and December 2023.
Fed Funds Futures currently think tomorrow’s 2022 Dot Plot will look something like this (using the odds listed in the CME FedWatch tool and multiplying those by the number of committee members):
- 1-2 dots at 1 rate increase next year
- 5 dots at 2 rate increases
- 6 dots at 3 rate increases
- 4 dots at 4 rate increases
- 1-2 dots at 5 rate increases
Now, the reality is the committee clusters its projections more than this, but the market clearly expects the bulk of the Dots to be between 2-4 rate hikes in 2022 and evenly spread around 3 hikes. If they skew more hawkish (a modal estimate of 4 rate hikes, for example), we expect equity markets to sell off fairly hard.
#3: If we do get a +2 percent S&P selloff, we recommend watching the CBOE VIX Index for signs of a bottom. The levels to watch are:
- 28: 1 standard deviation (8) from the long run mean (20)
- 36: 2 sigmas away
- 44: 3 sigmas away
Ideally, we like to see the VIX reach the next level once it moves 2-3 points above the prior level. Alternatively, scaling in additional equity exposure at a VIX of 28, then 36, then 44 is also a reasonable approach.
#4: We will also be watching 10-year yields tomorrow, and not just because the announcement of a faster tapering of Fed bond purchases should shift them modestly higher. There is a time-proven, if simplistic, recession indicator which measures the difference in 10-year and 3-month Treasury yields. When the spread between the two is zero or negative, a recession begins in the next 12 months. The New York Fed tracks this indicator monthly (link below) and it always gets attention as it nears the zero line.
The problem here is that 10-year Treasuries at 1.44 percent don’t leave much room for the Fed to raise rates by more than that (5-6 hikes, more or less) between now and 2022 – 2023 without flashing a recession warning. That fact will put the 2023 Dots under some scrutiny tomorrow. As you can see in the chart above, the FOMC’s modal estimate was for Fed Funds to be 1.00 – 1.25 percent by then. No doubt Wednesday’s new Dot Plot will see these shift higher, and closer to current 10-year yields.
Summing up: while we believe markets have discounted everything the Fed and Chair Powell will say tomorrow, there is the possibility that something will go awry. If so, we recommend buying any significant decline and, of course, we’ll be back tomorrow with our analysis of the Fed’s decision and the market’s reaction.
New York Fed Recession Model: https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf