By: Thomas Steffanci, PhD, Senior Portfolio Manager
The Federal Reserve’s latest policy meeting last week finally put some meat on the bone by concluding they would start the tapering of their $120 billion monthly purchases of government securities. Though they were inexact as to the precise timing, it appears the program will begin in November and finish up by mid-2022.
But there were a couple of things in the Fed’s statement that took the market by surprise. The Fed issues a detailed quarterly summary of what members of the Federal Open Market Committee (FOMC) individually forecast about the next 3-year movements in inflation, economic growth, and the Federal funds rate. Those estimates are summarized in a Summary of Economic Projections (“dot plot”) where each of the 18 members (including Chairman Jerome Powell) map their projections on a three-year ahead calendar. It’s there where the changes since the June summary had market impact.
In their last “dot plot” in June, seven of the 18 members thought that the Fed should start raising interest rates by the end of next year, rather than in 2023. In the latest one, half of the committee determined that 2022 was more likely (when the tapering was finished). They also pushed their longer-term interest rate estimates higher. One reason appears to be that during the interval between June and September, annual inflation (CPI basis) rose to 5% as supply bottlenecks and rising wages continued to increase business and consumer costs. Elevated risks to their estimate of “transitory” inflation appear to have prompted Fed officials to begin their tapering and to revise their interest rate timing and to increase their interest rate projections. Market watchers dubbed this as a hawkish turn in Fed policy.
At the same time, however, employment gains slowed and high frequency economic data on retail sales and manufacturing and service activity weakened. The specter of stagflation has begun creeping into economist’s lexicon, a legacy of the 1970’s. In previous meetings the Fed had emphasized that “substantial further progress” on employment would be needed for them to move to raise interest rates. In this meeting, the Chairman stated he is looking for “accumulating progress”, appearing to back off from his earlier statement. With eight million people still unemployed and the slowing in employment gains, the Fed’s message seems to be that inflation is now a more pressing policy issue, especially if the gargantuan $3.5 Trillion spending bill is passed.
So, what has the market impact of all this been? Bond yields declined initially as some investors believed that the start of a less accommodative policy and a possible rise in interest rates in 2022 would forestall more rapid increases required later to confront inflation. But that sentiment didn’t last long. The Fed’s preparing to end its ultra-easy monetary policy has also signaled that the economy would continue to strengthen in the short term, putting upward pressure on interest rates, a view that shortly began to dominate bond market sentiment. Bond yields quickly turned higher. In fact, they have touched multi-month highs. And it didn’t help that several European Central Banks have either ended their bond purchase program (QE) or have begun raising rates.
Stocks were a different story. They reacted bullishly and interpreted the Fed moves as affirmation that the economy was on a solid growth path, giving confidence to expectations of healthy gains in corporate earnings. In fact, the S&P 500 registered its largest 2-day gain since mid-July at 2.2%. Small cap stocks (Russell 2000) rose 4.2% and banks have surged by 6 1/4%, indicative of investor confidence in the ongoing cyclical upswing. The long-term equity uptrend continues despite a changing Fed policy and an eventual rise in interest rates.
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