Note: I don’t typically post here outside of the normal weekly schedule, but enough happened coming out of the Fed’s meeting this week and Jerome Powell’s subsequent comments that I felt compelled to offer up some thoughts.
The unquestioned major market event this week was the Fed Open Market Committee meeting. Everyone was watching to hear what Jerome Powell would say about the direction of quantitative easing & plans for interest rate increases in 2022. It’s safe to say that Powell didn’t disappoint.
It’s silly to look back and think now that I thought Powell might strike a bit of a dovish tone in light of financial market volatility over the past couple weeks. Instead, he managed to sound even more hawkish in his quest to fight inflation. The markets have priced in 4 quarter-point rate hikes in 2022 and now it sounds like even that might not be aggressive enough.
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The day started normal enough with some volatility in the early going before Powell took over. Worth noting is how the markets rallied once the initial statement was released, but then turned south after Powell started to speak.
Powell Calms The Markets By Confirming What’s Expected…
The markets love certainty and that’s largely what the Fed did when its initial policy statement was released. There was no rate hike at this meeting as expected, but did say that “it will soon be appropriate to raise the target range for the federal funds rate”. This effectively confirms that a rate hike in March is very likely and keeps in line with the widely-held belief that there will be four rate hikes in 2022. The market got what it expected and stocks ticked higher by roughly 0.5%. Nothing unusual so far.
…But Then Undoes It In The Q&A
Here’s where things get interesting. In another statement, the Fed indicated that “The Committee expects that reducing the size of the Federal Reserve’s balance sheet will commence after the process of increasing the target range for the federal funds rate has begun.”
This is a more hawkish position on tightening than the markets wanted. Investors were expecting rate hikes, but had hoped that a reduction in the Fed’s balance sheet wouldn’t occur until rates had been increased several times. Here, Powell is indicating that rate hikes and quantitative tightening could occur side-by-side.
From a pure inflation standpoint, this approach makes sense but it also highlights how the Fed’s “kick the can down the road” policy decisions up to this point have put it in a tough and unenviable spot. Since the central bank was so slow to respond to rising inflation and slowing growth expectations (arguing that a labor market with a 4% unemployment rate was somehow “weak”), it now needs to play catch-up in a big way. It’s interesting that just a few days ago, President Biden essentially mandated the Fed to clean up the current inflation mess and Powell taking this tone might be a response to this.
When I read back some of what Powell said during the press conference in terms of balance sheet reduction, labor market strength, the need to control inflation and the need to raise rates quickly, this is almost a version of Powell that I didn’t think existed. He’s spent years being incredibly careful in not tipping the boat and spooking the financial markets. It’s been this approach that caused the Fed to keep interest rates low and asset purchases continuing for much longer than was warranted.
Perhaps an apt analogy to his newfound aggressive tone would be driving down the road and finding your car drifting towards the centerline. Logic would say you gradually and gently pull yourself back into your line. Powell seems like he’s ready to jerk the wheel to the right and potentially run the car off the road. That overcompensation is what I’m worried about most at this point. I’ll get into that in a second.
Powell Hints That Inflation Might Not Be Done
This is probably a big contributing factor to why stock prices pulled back in the afternoon. The markets have largely priced in the fact that we are at or near peak inflation and the year-over-year rate of change will drift lower as the year progresses. Powell’s indication that we may not yet be at peak inflation is surprising and maybe a reason why he’s sounding so aggressive. He did use the word “prolonged” and acknowledged that supply chain issues were taking longer than expected to resolve.
If this turns out to be true, the possibility of aggressive Fed action runs the risk of slowing economic growth even faster than expected and ushering in a possible recession in the next 12-24 months.
Absent shorter-term considerations, it’s hard to argue that we’re not closer to the next recession today than we were yesterday. The markets seem to agree. The 10Y/2Y Treasury spread shot lower. Treasury yields shot higher, especially on the short end. Credit spreads, which hadn’t really budged throughout all of this, moved higher as well. Industrial commodity prices, including lumber, continue moving lower.
Many market pundits today are probably talking about ways that stocks could keep moving higher despite all of this, but I’m taking the opposite view. If we pull back to a 30,000 foot view, I can’t help but arrive at one conclusion - economic growth is likely to slow quickly (although the Q4 reading was encouraging) while the Fed will be aggressively tightening monetary conditions. Those two things tend to fly in the face of each other and can be a bad combination when happening at the same time.
I think the likely longer-term outcome is that inflation flips to deflation, the Treasury curve inverts again and we’re back to loosening conditions within the next two years. That also means stocks are primed for a further pullback, something we’ve already seen the start of.
Powell and the Fed have a history of misstepping on their policy decisions. I fear they’re about to do it again.
ETFs To Consider
Since this is an ETF-focused blog, it’s probably appropriate to highlight a few options that could be appropriate in this environment. The Aptus Defined Risk ETF (DRSK) invests in corporate bonds with an overlay of call options on U.S. large-caps. The Global X S&P 500 Risk Managed Income ETF (XRMI) and the Nationwide Risk-Managed Income ETF (NUSI) invest in a basket stocks while selling covered calls and buying protective puts. The strategy helps mitigate tail risks and deliver a 7-9% yield. The AGFiQ U.S. Market Neutral Anti-Beta ETF (BTAL) buys low volatility stocks and shorts high beta ones, meaning it generates gains whenever high beta underperforms.