Wait a Minute: Fed Grows Hawkish and Bonds, Stocks Rally?

The September Federal Open Market Committee meeting was highly anticipated and it didn't disappoint. Fed Chair Jerome Powell not only overtly telegraphed the long-awaited tapering, but gave a very specific time horizon. In addition, the dot plot showed a significant hawkish tilt, but for some reason, longer bonds and stocks both rallied. Here's my take on what happened and why markets are trading at odds. Taper Soon and Fast As expected, the Fed didn't quite announce tapering of quantitative easing purchases, but Powell was pretty plain that tapering would be coming at their next meeting in November. Powell went further than I expected by basically giving us a timeline for ending QE entirely, saying that the taper would be complete by the middle of 2022. That probably means they will be cutting QE purchases by $20 billion per meeting starting in November. As I've said before, QE tapering is mostly about financial market plumbing at this point. Every dollar of bonds that the Fed buys creates a dollar of reserves in the banking system. Right now, banks are choking on this rapid reserve growth, and they are flooding the short-term rates market, looking for a home for all this excess. This is why the Fed keeps having trillions of subscriptions at their repo auctions. This is a level of distortion that isn't serving any useful purpose, and I expect the Fed just wants out of the QE business. However, I do take Powell at his word that the timing of tapering doesn't have any particular bearing on the timing for rate hikes. That being said... Dot Moves Are More Hawkish Since some kind of tapering announcement was a given, most of the focus heading into this meeting was on the so-called dot plot, where each FOMC member states where they would set rates if their own economic forecast came to fruition. This part is extremely important. The dots don't tell us where rates are going, rather they tell us how the Fed would react to a certain set of data. In this case, the FOMC as a group now expects inflation to be a bit more lasting than was the case in June. The Fed raised its core personal consumption expenditure forecast for 2022 to 2.3% (from 2.1%) and 2.2% in 2023 (also from 2.1%). Given this change in forecast, it is only logical that more members would favor rate hikes. Put another way, if core PCE ends 2022 at 2.3%, just about every member of the FOMC will think rate hikes are appropriate. That isn't too surprising. It is notable that two FOMC members raised their dots off zero for 2022. We don't know who they are, which also means we can't tell how influential they will be. But it is fair to say that hikes in 2022 are not at all priced in, and yet about half the committee thinks such a move would be reasonable. I think the bar is very high for a 2022 hike, but I also don't think we can rule it out. What is perhaps more interesting to me is the 2024 dots, which are new to the forecast this meeting. Now we should definitely be careful over-interpreting the dots out this far. A lot can happen in three years. But the delta between the '23 dots and the '24 dots tells us a lot about normalization. For example, is the FOMC thinking that rates move slowly, but steadily, higher until they hit some magical normal number? Or in the spirit of AIT, are rates going to be more fluid? Moving higher only as inflation data proves they need to move higher? I am looking at this by mapping each '23 dot to one of the '24 dots, basically by assuming the highest '23 dot is also the highest of the '24s and then going down from there. While I'm not surprised by the outcome of this exercise, I am disappointed. Most members figure it will be appropriate to accelerate rate hikes in 2024, which sounds like the old regime of normalization is still ruling their thinking. To me this implies they are assuming that whatever the normal rate is, it is best to hurry up and get there. Now to be fair, these dots have very little bearing on what will actually happen three years from now. Not only does it depend on what the economy does, but each FOMC member will be highly influenced by the rest of the committee when it comes time to set policy. But these more aggressive 2024 dots do tell us that by default, most members want to hike and hike often. What Are Bonds are Saying? Watch Out ... We got a bull flattener post-FOMC, with long-term yields falling, while shorter-term yields wound up about unchanged. This kind of market move suggests the market thinks near-term rate hikes will be a mistake -- that the U.S. economy can't handle more than a couple hikes before growth becomes impaired. Or put another way, the U.S. economy has become more like Europe's. I'm not sure I agree with such a pessimistic outlook, but there definitely are risks. The lack of labor participation growth is effectively like making our demographics worse. Continuously snarled supply chains could put a cap on how fast gross domestic product can grow. I think it is likely that both the labor supply problem and supply chains generally can solve themselves, given time. But readers should know that the scenario where yields stay extremely low is a reasonable outcome. I'm honestly not sure why stocks maintained strength into the close on Wednesday. The Fed isn't taking the punch bowl away per se, but it is saying they won't remain accommodative forever. It isn't a disaster for stocks of course, it is just a little odd that they'd gain strength. Calm Before the Storm The narrative that the U.S. can't handle rate hikes has been a major reason why bond yields have rallied into the 1.20%-1.30% area on the 10-year. In the short-term, higher inflation prints or strong jobs reports won't upset that narrative, since the thesis is really about what conditions are like into 2022 and 2023. So we could see bond yields churn around these levels for a while until enough evidence accumulates that inflation will be a lasting problem. Or not.

Wait a Minute: Fed Grows Hawkish and Bonds, Stocks Rally?

Let's sort out the FOMC meeting, what bonds are telling us and how this could all play out.

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