For the first time, in a long time, the FOMC did not out-dove the market. While the prevailing bias was for the dot-plot median forecast to move higher, the increase to 0.625%, representing two full hikes by the end of 2023 was a genuine shift in the committee’s consensus beliefs. The key question is whether that is just a change in tone or a genuine shift in the reaction function that had previously been focused on the shortfall in employment. From our perch, it was probably a little bit of both. Afterall, in spite of the complexity in assessing macro conditions after a pandemic-driven recession, it is hard for the FOMC to deny that the US economy is on fire. They are human beings as well with behavioral biases.
The way price has responded to news – so far – is also consistent with a moderate hawkish surprise, Treasury yields higher, 5-30 yield curve flatter, dollar strength and bank equity outperforming. The good news is that the broad equity indices have recovered from their initial reaction lows. On the positive side, the Fed has merely signaled what they might do at some point in the future, rather than commit to a specific timeline on a “taper” of the asset purchase program or pledge to normalize rates. Moreover, as we noted earlier this week, the rise in consumer price inflation has effectively loosened monetary policy further in real terms over the past few months and the level of real rates is still exceptionally accommodative. Stated differently the real equity risk premium is still abnormally high.
The FOMC statement and communication in the press conference did not really offer any hints of a taper, which will likely be the first policy shift implemented to reduce accommodation. Rather, the market’s focus was on the shift in the projection of interest rate policy in the future. As we noted above, the median dot-plot moved increased to reflect two full hikes by the end of 2023. While Jay Powell emphasized that the dot-plot “needs to be taken with a grain of salt” and does not represent the central forecast of the committee, if they include it in the statement, market participants will focus on it.
Three key elements of the summary of economic projections appeared to change. The first was a fairly modest improvement in the forecast of the unemployment (a reduction of 0.1% for next year). However, that is probably not enough to warrant a shift in policy rate expectations. Second, the distribution of PCE forecasts for the next few years moved higher, particularly in 2022. Third, the shift in the Committee’s inflation and policy rate expectations suggests that there is also an evolution in the reaction function in spite of the prior emphasis on the shortfall in employment from pre-pandemic levels. Even the Chairman was slightly less dismissive of recent inflation pressure. The big picture point is that there appeared to be a genuine shift in tone even if they only started to talk about tapering.
In the near term, we remain constructive on equities because policy (monetary conditions and fiscal) remain exceptionally loose. Equities tend to outperform until the output gap closes and the level of real rates means that the equity risk premium remains abnormally high. However, as we have noted over the past few weeks, excess liquidity peaked in Q1 this year and we have also probably reached “peak” monetary policy support for markets. Equities still tend to perform well as the market transitions to mid-cycle and policy normalizes, but returns will likely become more challenging, particularly for speculative (non-profitable) companies. That is a key reason we have a focus on cash flow (short duration), strong balance sheets, dividend growth and pricing power. Sectors such as banks that benefit from rising rates, will also provide portfolio diversification.
Looking further out, the paradox for the Fed is that the longer they delay policy normalization and liquidity withdrawal, the more leverage will build and asset prices will rally. Stated differently, the Fed’s desire to signal a smooth path to policy normalization and maintain “stability” will lead probably to even greater instability once liquidity is eventually withdrawn. In December 2018, a real Fed Funds rate of just under 1% was enough to cause an episodic decline in equity prices. Today’s real short term rate is more than 400 basis points below that level (and equity prices are a lot higher). In that context, buying protection will likely be necessary at some point in the not-to-distant future. Of course, it is also why some people argue that there is no exit from the monetary equivalent of Hotel California.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.