Investors in the stock and bond markets have already factored in a lot of hawkishness in their monetary policy forecasts. The assumption is that the Fed’s policy statement on Wednesday will expedite the winding down of asset purchases. In addition, the Federal Reserve’s updated quarterly economic predictions call for two rate hikes in 2022.
It would be a significant change from September. According to the most recent predictions, nine of the Federal Reserve’s 18 officials believe the first rate hike should be delayed until 2023. Still, there’s a potential that the Fed will surprise the stock market by being even more hostile and unfavorable.
Rate hikes come after the Federal Reserve’s reduction.
The Federal Reserve said on November 3 that it would reduce its monthly asset purchases from $120 billion to $110 billion as a result of the financial crisis. The early step down of $15 billion per month would have completed acquisitions of Treasuries and mortgage securities by June. However, Fed Chairman Jerome Powell told Congress on November 22 that policymakers might consider ending asset purchases “a few months earlier.” Several additional Fed officials expressed support for and openness to a speedier bond cut at the December Fed meeting.
At the December Fed meeting, Wall Street economists expect officials to reduce asset purchases by $30 billion per month, dropping to zero in March. The timing is critical because the Fed has long stated that it will maintain its benchmark rate until the promising alternative balance-sheet expansion is completed. As a result, interest rate hikes might start as early as March. But, of course, all bets could be off if the omicron variety proves to be pathogenic, according to Powell’s indication of a speedier Fed taper. Therefore, as demonstrated by early research, the omicron variation appears to be modest. The stock market jumped last week.
Even though Fed asset purchases are often viewed as a catalyst for rising stock prices, it implies that stock market investors aren’t overly concerned about a speedier taper.
Nonetheless, the rapid spread of the omicron strain in the United Kingdom may cause policymakers to rethink their rate-hike estimates. Stock prices and Treasury yields fell sharply on U.K.-led omicron worries, with tourism stocks leading the way. However, the producer price index data released on Tuesday, which revealed a startling 9.6% wholesale inflation rate, stunned IT stocks. Even after cutting intraday losses, the NASDAQ fell 1.1 percent. The S&P 500 lost 0.75 percent, while the Dow Jones Industrial Average fell 0.3 percent. CME Group predicts the probability of three Fed rate hikes by December 2022 as 61 percent, Tuesday morning.
Federal Reserve Mandates: One more to go
The Federal Reserve has begun raising its benchmark interest rate ahead of schedule in prior cycles to prevent the economy from scorching. Even while inflation stayed below target, the Fed assessed in 2019 that it had acted hastily, harming the economy and employment growth.
The Federal Reserve’s primary policy shift in August 2020 included two significant adjustments. Firstly, the Federal Reserve would no longer raise its key interest rate until the job market had reached full employment. Even then, the Fed would not raise rates unless inflation had been considerably above the 2% goal for some years. Powell recently told Congress that the latter of those tests had been passed. According to the consumer price index, inflation reached a 39-year high of 6.8% in November.
“The danger of substantially higher inflation has grown,” Powell stated, abandoning his previous assessment of inflation as temporary. The only remaining roadblock to rate hikes appears to be the hazily stated criteria of overall workforce.
How near are we to achieving employment growth?
Since February 2020, the labor force has shrunk by 2.4 million, with everyone either employed or searching for employment. At the same time, the working-age population (16 and up) increased by 2.4 million. However, there is less flexibility in the labor market than appears since the senior population has grown by 3 million as the oldest generation ages 75. As a result, older employees’ engagement in the labor force reduces typically to approximately one out of every five. Nevertheless, health-care-related risk, as well as a surge in the stock market and real-estate wealth, maybe offer older Americans additional reasons to retire or remain retired.
As per some data, the labor market is extremely tight. For instance, the Federal Reserve projected in September that the 5.2 percent unemployment rate would fall to 4.8 percent in the fourth quarter. Instead, the jobless rate has dropped a whole percentage point to 4.2 percent. Furthermore, new unemployment benefit claims have fallen to levels last seen in 1969. Moreover, data from October revealed that the number of job searchers had dropped to 67 per 100 positions, which is an 18% decrease from pre-Covid levels.
Powell has stated that while determining full employment, the Fed will evaluate inclusive indicators such as minority unemployment. Substantial pay increase among relatively low-paid earners, on the other hand, already passes the test. Employment among prime-age workers (ages 25-54) is still 1.9 million below pre-Covid levels. The main question is how quickly the job gap will be closed. If it occurs during the next six months, the Fed will have no reason to delay a quarter-point rate rise in June 2022.
Rate hikes and stock market
A June inflation would pave the way for three rate hikes in 2022, with more in September and December. Despite this, monetary policy would remain supportive, with the Fed’s target rate rising to a range of 0.75 percent to 1%, substantially below inflation.
Still, a third-rate hike would be a negative surprise for the stock market. Furthermore, the impact would most certainly differ by industry. Short-term Treasury yields have risen due to the Fed’s recent hawkishness, while long-term Bond rates have declined. This is because markets appear to believe the Fed will act too forcefully, resulting in longer-term deflationary consequences.
The flattening Treasury yield curve explains why bank equities have been struggling recently, while the entire stock market — particularly tech firms — has done well. When the yield curve flattens, banks’ net interest margins are squeezed because they borrow at lower rates and lend at high speeds. Meanwhile, a lower 10-year Treasury yield, which discounts future earnings to the present, tends to support growth-stock prices.
What’s on the Fed’s Financial Statements?
It is another risk that traders and investors should know, albeit it is unlikely to be a real and present threat. The question is what the Fed will do with the $4.5 trillion in assets it will have on its income statement once the tapering is finished. As those Treasury and mortgage securities expire, the Fed must decide whether to decrease its financial information or transfer the interest and principal into fresh acquisitions.
Last month, James Bullard, St. Louis Fed President, stated that he’d like to see the Fed “permit balance sheet runoff after the taper or immediately after.” In 2022, Bullard will be a voting policy member.
However, any hint that the Fed considers this option may cause the stock market to respond negatively. For example, the stock market had a bearish market scare in late 2018 when the Fed decreased its financial statement amidst interest-rate rises. As a result, the Fed had no choice but to stop it and resume balance sheet expansion in 2019.
Letting the Fed’s cash flow shrink “could also enable the Fed to address inflationary worries without raising rates too soon,” according to Aneta Markowska, the chief economist at Jefferies.
Any hint from Powell that an early balance sheet runoff is being considered might steepen the Treasury yield curve, according to Markowska. That could be beneficial to bank stocks but not necessarily to the stock market as a whole.