FINANCIAL MARKET UPDATE 12.21.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE FED PIVOT EXPLAINED

Last week, the Federal Reserve conducted its final monetary policy meeting for the year. While Fed meetings typically garner substantial attention from the markets, this meeting seemed to carry increased importance. Dubbed the ‘Fed Pivot’ by financial media outlets, the outcome marked a clear shift in the expected path of monetary policy. Here are the top takeaways from the meeting.

Updated Economic Projections

The Federal Reserve’s monetary policy-setting body is known as the Federal Open Market Committee (FOMC). The committee convenes every six weeks for a two-day meeting that is concluded by an official written policy statement and press conference from the Fed Chair, Jerome Powell. At every other meeting, the Fed publishes the ‘Summary of Economic Projections’ (SEP), which provides some transparency into the economic forecasts of individual committee members. An updated SEP was published at the December meeting. The median forecast for major economic variables like GDP growth, inflation, and unemployment are summarized in the table below.

Table 1. Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy, Dec 2021

The difference between the updated forecasts relative to the prior estimates was unusually large this time around. Fed officials had been hinting at the potential need for an adjustment. During congressional testimony at the end of November, Fed Chair Jerome Powell suggested it was time to ‘retire’ the word transitory to describe the current episode of inflation. Fed officials were finally coming around to the belief that the elevated levels were both more persistent and broader-based than expected. As a result, forecasted inflation in the near term was revised materially higher before ultimately moving back towards their 2% target in the long run. Additionally, the unemployment rate saw large downward revisions through 2022, while GDP growth also saw some mixed adjustments.

The Federal Reserve has a dual mandate of achieving maximum employment while ensuring price stability. The updated Summary of Economic Projections demonstrates a belief that both the labor market and inflation are running hotter than what was believed even a month ago. Given this new information, Fed officials are pivoting towards a more aggressive policy stance.

Accelerated Pace of Tapering

In the Spring of 2020, the Fed deployed some unconventional policy tools to support the market during the pandemic-induced lockdowns. One such tool, referred to as ‘Quantitative Easing’ (QE), had originally been utilized during the Financial Crisis in 2008. During both episodes, the Fed’s primary policy tool (short-term interest rates) was exhausted after being lowered to 0% (referred to as the effective lower bound).

QE involves Fed purchases of Treasury and agency mortgage bonds each month in the open market. Doing so enables the Fed to exert some downward pressure on longer-term interest rates, which are typically influenced by market expectations for growth and inflation rather than monetary policy. The Fed had been purchasing $120 billion per month of bonds since the onset of the pandemic.

At the November meeting, the Fed announced its intention to begin reducing the monthly pace of bond purchases. This reduction is commonly referred to as ‘tapering.’ The initial plan was to reduce Treasury bonds by $10 billion and agency mortgage bonds by $5 billion each month until purchases were halted altogether by mid-2022. At the December meeting, however, it appeared the Fed needed to act faster to confront inflation. They responded by doubling the pace of purchase reductions, and the program is now slated to conclude in March.

Sooner Rate Hikes, and More of Them

Throughout 2021, Fed officials have made it clear they would not begin raising interest rates until after the QE program had ended. The thinking is that it does not make sense to simultaneously add additional accommodation (i.e., more bond purchases) while tightening policy through rate hikes. The path toward policy normalization has been clearly defined as ending QE and then hiking rates. Therefore, a core purpose for accelerating tapering was to begin hiking rates sooner.

Part of the Summary of Economic Projections referred to as the ‘Dot Plot,’ is a graphical illustration of the anticipated path of the federal funds rate over the next few years. Consistent with the accelerated pace of tapering, the median estimate for the number of rate hikes in 2022 increased from one to three. As seen in the chart below, the federal funds rate is expected to be between 0.75% – 1.00% at the end of 2022. This marks a clear and dramatic shift (pivot) in expectations, as barely half of the committee members indicated even one hike for 2022 on the September Dot Plot. The update aligns the Fed’s expectations more closely with the market’s, which has been pricing in three hikes in 2022 for a while. The target rate is then expected to continue moving higher in subsequent years before peaking around 2.50%. It is important to note that 2.50% is still fairly low by historical standards.

While tighter monetary policy is generally considered a headwind for stocks, interest rates above 0.0% are justified given the strong labor market and rapid pace of economic growth. Large-growth stocks in the US do appear vulnerable given their rich valuations, though other areas of the market, including value stocks, small-caps, and international stocks, are much more attractive on a relative basis.

There has certainly been an uptick in volatility in recent weeks. Of course, some of that is attributable to the emergence of the new Omicron Covid-19 variant. Ultimately, how the stock market performs from here will depend on developments in public health, the ability of businesses to continue to grow earnings and maintain margins, how aggressive the Fed gets and how quickly they move, and how much of that shift in monetary policy has already been priced in.

WEEK IN REVIEW

  • Data published last week from the commerce department showed that retail sales grew by 0.3% during November, which represents a slowdown from prior months. On a year-over-year basis, retail sales grew by a robust 18.2%. Part of the slowdown is potentially an early start to the Christmas shopping season as consumers tried to stay ahead of product shortages and shipping delays.
  • The yield curve has been flattening in recent months, with the spread between 10-Year & 2-Year Treasury yields falling from a peak of 1.6% in March to just 0.8% this week. This move is somewhat counter-intuitive, as expectations for faster growth and higher inflation typically put upward pressure on longer-term rates like the 10-Year. The general explanation is that the market is expecting the pivot in Fed policy will be successful in taming inflation and potentially detrimental to economic growth.
  • Earlier this week, the Conference Board published its Index of Leading Economic Indicators, which came in higher than expected. Additionally, Q3 GDP was revised from 2.1% to 2.3%, and consumer confidence beat expectations. Later this week, we will get an alternative look at November inflation, as well as updated data on durable goods orders.

HOT READS

Markets

  • Millennials Are Supercharging the Housing Market (WSJ)
  • U.S. Manufacturing Production Near Three-Year High in November (CNBC)
  • U.S. Retail Sales Slow With Holiday Shoppers Facing Inflation, Shortages (WSJ)

Investing

  • What’s Not to Like About a Fund With a 7% Yield (Jason Zweig)
  • The Future Seen (Humble Dollar)
  • Finding Some Middle Ground Between Paul Volcker & Jerome Powell (Ben Carlson)

Other

  • ‘Self-Driving’ Cars Begin to Emerge from a Cloud of Hype (Scientific American)
  • How Nasa’s New Telescope Could See Back to the First Galaxies – Video (WSJ)
  • Boom’s Quest to Make Supersonic Flights a Reality (Again) (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER, PRINCIPAL

Josh Jenkins is a Chief Investment Officer and Principal at Lutz Financial. With 12+ years of relevant experience, he leads the Investment Committee and specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. He is also responsible for portfolio trading, research and thought leadership, and the division's analytics and operational efficiency. He lives in Omaha, NE.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading Team Oversight
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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