Cut to the Taper: What to Watch Ahead of the Fed Meeting

This week's Federal Reserve Open Market Committee meeting is getting a lot of scrutiny from people who otherwise could care less about the meetings. Why? Rising prices. Investors, shoppers, the media and lawmakers are all concerned about inflation. I cannot, in fact, remember a time when so many politicians were weighing in on the Fed. I believe we are in for a sustained period of increased prices, but what I think doesn't matter. The Fed does a good job of not bowing to political pressures and pursues the policy it deems to be correct. So, let's see what it's thinking: It dropped the word transitory, because clearly many of the factors influencing inflation are lingering longer than it thought they would. Supply chains, underinvestment in traditional energy and Covid outbreaks are slowing down the normalization process. It is worth pointing out that monetary policy has little ability to impact these inflationary trends. Housing. Housing is one area that hits consumers. More people are pointing out that the shelter component of consumer price index up 3.8% in the past 12 months likely understates what has happened to housing. Housing is one area that has a link to monetary policy, so the Fed needs to consider that. The Fed wanted inflation. While inflation is suddenly unpopular with politicians, it might not be so unpopular within the Fed. Watching Japan spend decades in a deflationary environment has scared many economists and central bankers. So I'm far from certain that central bankers are as scared of inflation as media headlines suggest they should be. So, the Fed is a little nervous about inflation, but thinks much of it is out of its control and it will normalize over a longer period of time. Cut to the Taper The Fed has reduced Treasury purchases by $10 billion a month twice now and mortgages by $5 billion. We are currently at $60 billion of Treasury and $30 billion of mortgages. The Fed will accelerate the tapering and finish in the first quarter. It will signal that it is doing something to reduce easy money (and in theory inflation). Since it does buy mortgages, removing those purchases can be spun as being helpful in slowing housing inflation. Taper is largely a non-event for market participants. Hikes I expect the Fed to push back on hikes. My base case - Guide to zero or one hike: The Fed will highlight that it needs to see the impact of tapering, that it cannot control many of the inflationary pressures and it can talk about how it expects some things to normalize (it hasn't given up on transitory, it just will say it differently). There is a much higher bar to hike than to taper and the Fed will reinforce that. If we get this action, the market should respond positively. Yield curves should steepen. Corporate bonds (especially high yield) should do well. On the equity front, banks, cyclicals, materials, anything domestic, even value, should respond well. There might be some pressure on some high-flyers who track treasury yields, but even that weakness should be short lived as it will be more of a rotation into other sectors than people leaving equities. On the consensus of telegraphing one to three hikes: I think consensus is wrong here, but it is a possibility. Would be a late summer first hike type of indication. I think this is largely priced into the market. On the outlier view that the Fed signals three or more hikes: I don't see any way we get this messaging. The Fed may ultimately have to hike much more over the course of next year, but it isn't going to capitulate to that setting at this meeting. If somehow the Fed does this, look for a serious risk off movement. While some big firms have set this as their base case, there is virtually no one positioned for this stance. Bottom Line By the close of business Wednesday, we will know if it is clear sailing for markets into the new year, or whether we really have to adjust our thinking. I expect the Fed is more likely to give us clear sailing, but it doesn't hurt as we are back at the highs, to take some gains and free up capital just in case everything gets cheap (I still like the assets that I mentioned last week, but am not adding anything more until post FOMC).

Cut to the Taper: What to Watch Ahead of the Fed Meeting

As political pressure grows, what can we expect from the FOMC meeting this week?

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