Friday's Market Minute: Equities Face a Harsh Reality

This week, the Fed chief retired the term "transitory" when discussing inflation, months after failing to acknowledge that the FOMC underestimated how hot inflation would get and how long it would last. It is a late realization and confirms that the Federal Reserve is now in essence chasing inflation in an abrupt reactionary impulse. The Federal Reserve also ramped up tightening expectations with three rate hikes next year on the dot plot, and the market is now pricing in a 56% chance of a 25-basis point hike by March of next year. That is a significantly more aggressive pace than just a few months ago when policymakers were evenly split on the notion of a 2022 lift-off from today’s near-zero rates.

Powell justified the hawkish pivot by highlighting the underlying strength of the U.S. economy, which Fed officials expect to expand by 5.5% this year and 4% in 2022. Despite the optimistic economic outlook, equities have demonstrated a delayed – but nonetheless expected – negative reaction to the harsh reality of a pending contractionary monetary policy pivot. Treasury yields also remain under pressure. There is a big disconnect, especially on the long end of the curve, at how low yields remain and what Fed Chair Jay Powell and team are telling the market. The back end of the yield curve is where the perceived anomaly is, as it continues to refuse to buckle under the elevated inflation backdrop. Demand for treasuries is still robust despite the Fed’s intent on winding down QE liquidity injections sooner than expected.

In theory, the end of the Fed’s balance sheet expansion, which stands at $8.75 trillion dollars, in addition to robust economic growth, high inflation, and a tighter labor market all point to a sell-off in long bonds. In reality, U.S. Treasuries still yield a higher inflation and currency-adjusted return than developed country counterparts like Japan and Europe. The accelerated timeline for tapering by doubling the monthly reduction to $30 billion instead of the former $15 billion means the Fed will conclude their tapering process early in 2022. Despite the end of the current QE program, the Fed will not actually withdraw liquidity from the financial system until the first hike in interest rates. Key questions for market participants going forward will surround how aggressive the Fed will be when it comes to actually taking liquidity from the system.

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