Stocks greet Fed's hawkish turn with bullish embrace Stocks greet Fed's hawkish turn with bullish embrace\images\insights\article\fed-puzzle-dollar-small.jpg March 20 2022 March 18 2022

Stocks greet Fed's hawkish turn with bullish embrace

But is the equity rally a head fake?

Published March 18 2022

Bottom Line

Faced with the hottest nominal inflation in 40 years, the Federal Reserve voted to end its highly accommodative zero interest-rate policy and raise the fed funds rate by a quarter point this week for the first time since 2018. The Fed also plans to continue hiking rates at each of their six-remaining policy-setting meetings this year, with perhaps four more quarter-point hikes on tap over the course of 2023. 

If it weren’t for Russia’s unprovoked and unjustified military invasion into Ukraine, however, we believe Fed Chair Jerome Powell would have seriously considered a half-point rate hike. If inflation continues to rise in coming months while the Russian war cools, Powell hinted we could see one or more half-point hikes at coming meetings to help the Fed get out from behind the curve. Collectively, this could take the fed funds rate up to 3% or higher by the end of 2023.

The Fed also completed the tapering of its monthly $120 billion bond-buying program this month, and it will shift from quantitative easing (QE) to quantitative tightening (QT) soon. We expect policymakers to cut the Fed’s nearly $9 trillion balance sheet perhaps in half over the next five years or so. They would do this by either passively allowing instruments to mature or by actively selling bonds, perhaps at an average pace of about $75 billion monthly. We may learn of their specific plans at the upcoming May 4 or June 15 meetings. 

Selloff in bonds Reflecting the sustainable surge in inflation and the expectation of much tighter Fed policy, benchmark 10-year Treasury yields soared from nearly 1.65% on March 4 to 2.25% on March 16, the day of the Federal Open Market Committee meeting. But the yield-curve spread between 2- and 10-year Treasuries narrowed from 160 basis points a year ago to about 110 basis points six months ago to 20 basis points now. In our view, bond vigilantes are pricing in the increased risk of recession over the next two years, fearing a potential monetary-policy error if Powell fails to slay the inflation dragon. 

Extreme oil volatility As the Russian war rages on against the heroic Ukrainians, crude oil prices (West Texas Intermediate, or WTI) have nearly round tripped over the past three weeks, from $90 per barrel at the end of February to $130 on March 4 to $95 last Wednesday. Average national gasoline prices have soared 20% from $3.60 per gallon at the end of February to a record peak of $4.33 two weeks later. As a result, we expect February’s nominal CPI inflation of 7.9% annually to surge up towards 9-10% in coming months. 

Surprisingly positive reaction by stocks Faced with this increased stagflation risk of weaker economic growth and higher inflation, however, the S&P 500 surged more than 6% this week alone, the equity market’s best weekly performance since November 2020. But stocks appear technically overbought. The equity market has rallied right into overhead resistance at the 200-day moving average, and a so-called “Death Cross” formed a week ago with the 50- and 200-day moving averages. So might last week’s rally be a head fake for investors, with a resumption of this year’s downward trend in coming weeks? We continue to advise a defensive investment strategy with an equity overweight concentrated in relatively cheaper, less risky value stocks that enjoy higher dividend yield support.

Fed’s dual mandate rules Last week, President Biden’s nominee for the Vice Chair of Banking Supervision on the Federal Reserve’s Board of Governors, Sarah Bloom-Raskin, withdrew her name from consideration. Sen. Joe Manchin (Democrat-W.Va) said that he could not support Bloom-Raskin’s candidacy given her controversial climate and energy views, among other concerns, and she did not have enough other votes to overcome Manchin’s objections. 

The Fed’s dual mandate requires it focus its attention on the Phillips Curve tradeoff between stable inflation and full unemployment. But Bloom-Raskin and another Biden nominee, Lisa Cook, believe the central bank should expand its mandate to include other considerations, such as climate change, diversity and inclusion. The climate change issue, for example, is critical in the context of Russia’s war against Ukraine and the energy sanctions that the U.S. and their NATO allies have levied against Russia. 

As Biden decides on a new nomination, Sen. Sherrod Brown (Democrat-Ohio), chairman of the Senate Banking Committee, will need to drop his insistence on voting for all five of Biden’s nominees as a single up-or-down subcommittee vote as one block. The political optics of this strategy are poor, as it appears that Sen. Brown is attempting to use Biden’s re-nomination of Chair Powell for a second term as a human shield to gain favorable votes for his less-popular nominees. We expect that Powell and Biden’s two other nominees, Lael Brainard and Philip Jefferson, will be approved by the full Senate. 

Powell’s term expired at the end of January, and he was granted “Chair Pro Tempore” powers to continue to lead the Fed through the March 16 meeting until the Senate formally decides his fate. But the Fed’s task ahead is too difficult and important for political gamesmanship, leaving the seven-member Board of Governors understaffed. 

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Tags Markets/Economy . Equity .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Phillips curve: An economic model that portrays an inverse relationship between the level of unemployment and inflation on an historical basis but has come under doubt in recent decades. 

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Federated Advisory Services Company