Financial basis

The market rose on Fed rate hikes. What he might miss.

Text size

Fed Chairman Jerome Powell told reporters on Wednesday that the central bank has the tools to bring inflation down. Photographer: Julia Nikhinson/Bloomberg

This may not be the “all it takes” wish of former European Central Bank President Mario Draghi, but Chairman Jerome Powell made it clear on Wednesday that the Federal Reserve would make up for lost time by steadily raising interest rates and shrinking its balance sheet to bring inflation down. running at four-decade highs.

The bond market apparently believes that the US central bank can achieve this goal. Long-term Treasury yields actually track new projections from the Federal Open Market Committee calling for further quarter-point increases in the federal funds target range at each of its six remaining meetings this year. This was far larger than the actual quarter-point hike in its key rate announced by the FOMC following its two-day conference, in a range of 0.25% to 0.50%, which was expected after Powell almost promised it previously in recent testimony to Congress.

The 30-year Treasury yield fell 3.8 basis points (hundredths of a percentage point), to 2.442%. But the two-year note, the coupon maturity most sensitive to expectations of future Fed policy, jumped 6.6 basis points to 1.934%, the highest since June 2019. The benchmark yield 10-year rose slightly by three basis points, to 2.18%, which was almost equal to the five-year note at 2.176%, up 6.9 basis points on the session.

All of these movements in the Treasury market add up to a marked flattening of the slope of the yield curve, a classic signal that the market expects slower real growth accompanied by a possible easing of inflationary pressures.

The stock market, for its part, greeted this rather hawkish outlook for Fed policy surprisingly bullish. The leading averages reversed earlier losses and rallied after the FOMC announcement at 2:00 p.m. Eastern Time and at Powell’s subsequent press conference. Major averages ended up 3.77% for the Nasdaq Composite to 1.55% for the Dow Jones Industrial Average, while the benchmark S&P 500 rose 2.24%.

The rebound in the stock market suggests that the Fed’s monetary tightening may lead to an easing of inflationary pressures without harming economic growth or profits. Such an outcome would be much desired but is less likely.

Bond and equity markets are circling on their respective prospects, observes Julian Brigden, president and co-founder of Macro Intelligence Partners. The debt market continues to underestimate the degree of tightening predicted in the latest FOMC projections.

The so-called dot plot of the committee’s estimates for the end of 2023 ranges from 2.4% to 3.1% and in 2024 from 2.4% to 3.4%, with medians of 2.8% to the end of two years. That would be higher than the committee’s estimate of the longer-term break-even federal funds rate of 2.4%; translation, tight rather than easy, money.

The stock market appears to be overly optimistic about this hawkish outlook, Brigden adds in a phone interview. Powell pointed out during his press conference that the Fed is monitoring a variety of indicators to gauge financial conditions. As long as the equity market remains buoyant, Brigden says the Fed will continue to tighten.

In addition to the dot charts, which imply the Fed would raise the fed funds rate by 25 basis points at every meeting this year, Powell added to his presser that if inflation does not decline as expected as the economy remained strong, the central bank could raise rates further. As if to underscore the Fed’s hawkish nature, Wednesday’s vote to start raising rates included a dissent from St. Louis Fed President James Bullard, who favored a half-point increase.

The Fed also wasn’t deterred from starting to raise rates by the effects of Russia’s war on Ukraine, Brigden also pointed out. And in response to a question at his press conference, Powell admitted in retrospect that it would have been better if policy normalization had started sooner because factors such as supply chain issues didn’t pan out. eased as quickly as the Fed had expected.

Finally, Powell was also eager to point out that the Fed was ready to announce the start of the trickle down of its securities holdings. The central bank had more than doubled the size of its balance sheet to almost $8.9 trillion since the start of the Covid-19 pandemic in March 2020, which had the effect of massively increasing liquidity in the financial system. .

Powell said the FOMC could announce plans to reduce its balance sheet as soon as the next meeting on May 3-4. He indicated that the balance sheet runoff would be faster and start earlier than the previous episode in 2017-2018 https://www.stlouisfed.org/open-vault/2019/july/what-is-quantitative-tightening# :~:text=The%20Fed’s%20Balance%20Sheet%3A%20Runoff&text=The%20caps%20started%20at%20%246,%2420%20billion%20per%20month%2C%20 when the central bank let the securities arrive due after its quantitative easing in response to the financial crisis of 2008-2009. The reduction in securities holdings this time around could be equivalent to another hike or two in the fed funds rate.

Powell stressed that the Fed would be alert to market conditions and support financial stability as the central bank normalizes policy. History shows that when the Fed tightens policy, bear markets and recessions tend to follow.

Given the stock market’s exuberant reaction to Wednesday’s policy announcement, he apparently thinks the worst has already been discounted in the modest pullback in major averages from their recent highs. Or that this time it’s different.

Write to Randall W. Forsyth at [email protected]