The Fed Is Driving, and He Can Hit the Gas, or the Brakes, as He Likes

The U.S. Federal Reserve continues to inch toward lift-off. The Fed on Wednesday finally explicitly said that it will end Quantitative Easing in March and rate hikes would begin shortly after. After two years of zero-interest rates, we are finally going to find out whether the economy can handle higher yields. Here are my takes on this Fed meeting and what to expect in the coming weeks. Fed Follows Through on Guidance The Fed did not break major new ground at the meeting, and instead mostly followed through with moves that had already been telegraphed. At the December meeting they announced a QE tapering pace that would result in the program ending after February. That pace was left unchanged. The Fed also telegraphed that it would soon be appropriate to raise rates, which is clearly a suggestion that the first hike will come at their next meeting in March. This guidance is new in the sense that nothing so overt had been said before in post-meeting communications. But a March rate hike has been discussed by a number of Fed speakers in recent weeks and thus has been fully priced in by markets. Why Not Do More Right Now? What might be surprising to some is that they didn't do more. Why not hike immediately? Or end QE right now? Or telegraph a 50 basis-point hike in March? Reality is that the Fed is an incremental institution. They value consistency and predictability. We can see this in how QE tapering was handled. The Fed waited way too long to even start tapering, but that was because they were hell-bent on making sure markets were well-prepared. First the Fed hinted tapering was possible, then hinted it was imminent, and only after months of such talk did they finally act. While every action might not be as drawn out as the tapering, it does illustrate the Fed's strong desire to avoid surprises. So while it is certainly possible the Fed decides to speed up rate hikes at some point in 2022, they aren't going to intentionally shock the market. By the time an action is taken, it won't be a surprise. Did Stock Market Volatility Influence the Fed? Stocks have struggled so far this year, with the S&P 500 falling almost 9% so far year-to-date through Tuesday's close. There was some chatter that this volatility would influence the Fed's communication coming out of this meeting, particularly since consternation around rate hikes is the proximate cause of the selloff. The Fed certainly relies on stock prices and other financial market indicators. But these are used to gauge future expectations for the real economy. Right now the selloff is mostly about a rebalancing of valuations, not expectations for a weaker real economy. Some have pointed out that the Fed paused hikes in 2016 and 2018 after significant stock market corrections. However current markets are very different from either of those years. In both of 2016 and 2018, traditional macroeconomic indicators also suggested the broader economy was slowing. Those periods also saw credit markets sell off substantially. Neither of those two things are happening now. That's not to mention that inflation was at or below 2% in those periods, whereas it is problematically high now. The idea of a Fed put is not wholly incorrect, but is misunderstood. The Fed wants to do whatever it can to prevent recessions, or barring that, make recessions as painless as possible. To the extent that works it has a major influence on equity valuations. In theory, it keeps expansions going for longer which should make earnings less volatile. All else being equal, that allows stocks to sustain higher multiples. That's different from saying the Fed targets stock prices. I think we are seeing that distinction in the difference between how the Fed is acting now vs. how it acted in 2016 or 2018. Shrinking the Balance Sheet The Chair did not elaborate much on how quantitative tightening (QT) will work, other than to say that interest rates would be their main tool for monetary policy, that they wanted balance sheet run-off would be predictable, and that QT would mostly happen via run-off. What this tells us is that if the Fed needs to get more aggressive about policy tightening, they will be hiking faster. Most likely once they set the rate of balance sheet run-off, they will leave it on auto-pilot, at least for a period of time. 'Humble and Nimble' During the press conference, Powell emphasized that the committee needed to be humble and nimble about the outlook, and that the fed would be led by incoming data. Asked about whether rate hikes could happen more often than every other meeting, he said the Fed had made no decisions about the path going forward. I believe Chair Powell wants to widen the range of market expectations. In other words, have markets believe that two to three rate hikes are possible and five to six are possible, all depending on data. Under the Average Inflation Targeting framework, the Fed should be reacting to data, not anticipating it. For that to be credible, the Fed needs markets to actually believe that anything is possible. Look for more of this humble and nimble phraseology. It helps build in flexibility for them to ramp up hikes if necessary, but also pause if necessary, while committing themselves to neither. Market Reaction Although the Fed gave us no specific actions at this meeting, the chair's tone during the press conference was relatively hawkish. He specifically said that the economy was in a very different place than 2015, when rate hikes were extremely slow and ultimately only got to 2.5%. He also said there is quite a bit of room to raise interest rates without threatening the labor market. Both those statements hint at Powell's comfort with moving faster than markets have currently priced if necessary. Powell also said that his own assessment of inflation has probably moved up since the last official projections, which were just six weeks ago. After these statements, the bond market sold off, with the 5-year Treasury rising to 9bps during the presser. Stocks also sold off, erasing a 2% gain on the S&P 500. It is likely that expectations for Fed policy ebbs and flows over the course of 2022. Regardless I think the risk to five to 10 year bond yields are skewed to the upside. If inflation subsides back toward 2% over the course of 2022, the Fed probably still hikes 3-4 times in 2022 and a couple more in 2023. If fed funds gets to 1.5% or so before the Fed stops, then Treasury yields in the 5-10 year area are already fair value. But if inflation either doesn't subside or even if it just remains solidly above 2% into 2024, the Fed will wind up hiking much more than 1.5%, and current bond yields are too low. Remember that the median Fed dot for 2024 was at 2.125% assuming that core personal consumption expenditure was 2.1% at that point. This tells us that all it takes for the Fed to keep slowly hiking would be inflation above 2% by any degree. Obviously 2024 is a long way off, and a lot can (and will) happen. But I think the market is overly sanguine about the potential for growth and inflation to remain robust, and are too confident that the Fed will pause hikes merely because inflation slows a bit. While it is certainly possible that inflation could slow on its own, the risk is to the upside.

The Fed Is Driving, and He Can Hit the Gas, or the Brakes, as He Likes

Will it be two or three rate hikes, or five or six? Buckle up, because the Fed needs markets to believe that anything is possible.

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