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The Fed’s New Policy — Everything You Need to Know

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Everything the Federal Reserve announced Wednesday was both expected and a boost to many sectors.

First, here’s what the Fed said:

The federal funds rate — or the benchmark short-term lending rate that runs through the banking system — will remain pinned near 0% through at least 2023. The economy needs rates to stay low. Not only is the economy emerging from a deep recession, but with about half of the country’s small businesses still not fully reopened, liquidity and a low cost of borrowing is vital for employment and economic demand. The economy is recovering quickly, but that will only continue if stimulus remains a substantial part of the economic equation.

The Fed experts GDP growth to be 4% in 2021. That’s particularly a positive, as it confirms the economy is indeed on track for a fast recovery with levels of output almost mirroring those of 2019. Growth should moderate to between 2% and 3% by 2023. The central bank is looking for the unemployment rate to fall to 7% by the end of the year. It had risen to above 15% as shutdowns were imposed, but it has now fallen to below 10%. The Fed expects unemployment to fall to 6.5% in 2021 and steadily move towards 4% in the long run, the rate traditionally estimated as full employment. Inflation is expected at 1.7% in 2021 and 2% in the long-run.

All of this is positive, giving equity investors the green light to remain invested. The S&P 500 after having risen about 0.3% by midday, rose 0.6% by 2:30 PM EDT. That move wasn’t on the strength of growth tech stocks, which are not fully correlated to changes in the economy. Instead, economically-sensitive stocks, or cyclicals, rose considerably. Consumer discretionary rose more than 1.5%. Manufacturing companies like industrial equipment makers and materials companies rose about 1.5%. The price of crude oil rose 4.8% to $40 barrel and oil stocks rose about 5%.

The Fed’s comments on inflation hitting 2%, not rising above, were key as well. The Fed’s policy, updated a few weeks ago, is to raise rates only when inflation has run higher than 2% for some time so that it will average 2%, not when inflation first hits exactly 2%. This gives the low rate environment a long runway to support the economy, which was struggling to grow at a fast pace even before it was walloped by the pandemic. “It [ the announcement] really is quite dovish, particularly in light of the big improvements in the Fed’s near-term outlook for the economy,” wrote Brian Coulton, Chief Economist at Fitch in emailed remarks to reporters. "PCE inflation has averaged only 1.5% over the last ten years so it needs to sit at 2.5% or above for a long while to get the average rate back up to 2%. Moreover it now sounds like unemployment has to fall to 4% or less before they start raising rates. Its increasingly looking like no rate hikes until 2024.” One must give some credence to the idea that rates may rise at some point in the next few years if the economy truly begins to run hot, but if growth returns to pre-pandemic levels (slow growth), rates will likely indeed remain ultra low.

Treasury yields rose Wednesday. They have been pressured of late — by design. That has been supporting stocks, not only because it fundamentally boosts valuations, but also because with interest rates offering no real return over inflation, investors have little alternative than to pay a premium for stocks. After having been stuck at around 0.67% for a few weeks, the 10-Year Treasury yield rose just a tad to 0.68% by 2:30 p.m., as investors finally see some incrementally higher likelihood of inflation driven by strengthening economic demand. The 30-Year treasury yield rose to 1.44%. With the expanding yield curve, bank stocks rose 3%.

The Fed also said it will increase the size of its treasury buying program, in which it buys longer-term treasuries in order to keep rates low and therefore corporate and household borrowing costs low. This should pressure yields over time, even as inflation hopefully enters the fray.

Stock investors had been well assured the Fed would continue with such accommodative policy. "The Fed’s inertia was largely expected,” wrote Jason Pride, chief investment officer of private wealth at Glenmede in email remarks to reporters. "While monetary policy itself cannot solve the underlying cause of this recession (i.e. the pandemic), it can prime the economy for a stronger, more durable recovery once the dust finally settles on this pandemic.”

Earnings multiples, or valuations, have already reflected an incredibly low interest rate environment and many question whether the Fed’s policy can meaningfully boost stocks from here. But on Wednesday, the Fed’s economic messaging and minor value-added policy tweaks for the economy and markets are providing more assurance for investors to buy stocks.

Importantly, many beaten down and debt-laden consumer discretionary stocks like Nordstrom  (JWN) , Kohl’s  (KSS)  or United Airlines  (UAL)  rose as much as 5%, while stocks of the strongest brands that have run up to expensive valuations (which analysts admit to) were underperforming. Lululemon Athletica  (LULU)  fell 1%. Nike  (NKE)  fell 0.1%. Starbucks  (SBUX)  rose 1.5%.

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