The US equity market’s response to today’s FOMC meeting, new Summary of Economic Projections, and Chair press conference was in line with the confidence we have expressed in recent notes. We gave you a playbook in case we were wrong (because hubris and profits never mix), but markets today sighed their collective relief that everything came out as expected.
Five brief thoughts on today’s events:
1: Markets believe a faster tapering of bond purchases signals that the Fed will be raising rates sooner. Chair Powell took pains to separate these 2 forms of monetary policy, but Fed Funds Futures shrugged off those observations:
- Post-press conference, the odds of a March 2022 rate hike were basically 50:50 (46/54, to be precise).
- Yesterday, the odds of a March hike were only 33 percent.
- The odds that rates will be higher than today in May 2022 went from 57 percent yesterday to 65 pct today.
Takeaway: Fed Funds Futures, which have had the early and correct call all year (and better than most investment bank economists, we would add), think the first rate hike is most likely 3-5 months away. That is perfectly OK for stocks; the first hikes are not historically rally killers unless there is a 50 basis point move in the mix. Little chance of that happening in 2022.
2: The Fed’s December Dot Plot of the FOMC’s expected path of 2022 rate policy was exactly what Fed Funds Futures expected. We checked the CME FedWatch tool before and after the release of the Summary of Economic Projections, and there was almost no change. A comparison of the “Dots” and Fed Funds Futures odds:
- 1 rate hike next year: One Dot, 11 percent odds
- 2 hikes: 5 Dots, 24 pct odds
- 3 hikes: 10 Dots, 30 pct odds
- 4 hikes: 2 Dots, 22 pct odds
- More than 4 hikes: 0 dots, 13 pct odds
Takeaway: the Fed confirmed the market’s estimate of 3 rate hikes being the most likely path for monetary policy next year.
3: Powell addressed the question we posed in last night’s report: “aren’t you worried about what a 10-year Treasury yield at 1.46 percent says about 1) economic growth/Fed policy and 2) the Fed’s ability to raise rates above 1.5 pct?” His comments:
- Global sovereign rates are very low, with 10-year Japanese Government Bonds at 0.05 pct and German bunds at -0.4 pct. Of course investors will buy long dated Treasuries at seemingly low yields (and thereby keep them low).
- While he did not explicitly mention it, the latest SEP Dot Plot showed the FOMC believes long run policy rates should be around 2.5 percent. That’s a full point higher than current 10-year yields. This shows that it is not just Chair Powell that thinks current 10-year yields are no constraint to future policy.
- In a genuinely amusing nod to his own misstep back in 2018 – “we learned a lot in the last cycle”- Powell reiterated that policy will not be set by dogmatic perspectives on the neutral rate of interest.
Takeaway: Powell may not be worried about the 10-year trading below 1.5 percent, but we think equity markets would be more comfortable if yields rose closer to 2.0 percent over the next year. Our current reader survey (link at the top of this note) asks about this very point, so be sure to take it and let us know what you think!
4: “This is not the inflation we wanted.” That will be the single line we will remember most vividly out of this press conference. What did Powell mean by this? The Fed was hoping for modest inflation, driven by a tight labor market. What it got was much higher inflation, driven by supply chain issues as well as labor shortages. That is seeping through to the US economy as a whole after being contained to a handful of items earlier in the year.
The Chair Powell “pivot” to worrying about structural inflation began after the Employment Cost Index report of October 29th (+4.1 pct for private sector workers). Those concerns grew with the following Friday’s Jobs Report (+531,000 added) and then CPI report (+6.2 pct). That is what caused the change of heart which led to today’s accelerated tapering announcement.
Takeaway: even with a faster taper and 3 rate hikes next year, the Fed still needs supply chains to open up and consumer spending to normalize back to incremental outlays on services rather than physical goods. Fair enough – the market is making the same bet by assuming the Fed is not going down the path of a policy mistake.
5: There were 2 very bullish messages out of today’s Chair press conference:
- The Fed does not see the latest pandemic variant as a threat to the US economy. They feel comfortable accelerating the pace of bond purchase tapering even with that overhang.
- The FOMC had its first discussion around the size of the Fed’s balance sheet today, centered on a review of the last runoff (reduction in size) back in 2018 – 2019. Participants appreciated the historical context, but Powell indicated they see the current economic setup as much better than in that prior period.
Takeaway: while the Fed has no better crystal ball than markets do, these messages were certainly reassuring. With those in their back pocket, we expect equity markets to rally through year end.