Friday's Market Minute: Equities Have Yet to Factor in Liquidity Withdrawals

The debate on inflation hasn't stopped the S&P hitting a new record, and the market is entering its best-performing month over the last 10 years. Absent an unexpected hawkish tone on rates next Wednesday from the FOMC, November may play out as a continuation of the year-end rally that began late September. This earnings season has shown corporate profitability is strong and consumers have, for the most part, been able to handle the recent wave of price increases and the end of pandemic related stimulus payments. Economic data suggests personal consumption expenditures increased at a 1.6% annualized rate in 3Q, a much slower pace than the previous two quarters, but still positive, nonetheless. Third-quarter GDP was 2.0%, a deceleration that was widely already priced in.

Transitory or not, it is clear the Federal Reserve has achieved its mandated goal on inflation. With the 10-year nominal interest rate below 2% and negative real interest rates across all bond durations, the opportunity cost of holding cash and equivalents is still high. Despite upcoming balance sheet tapering, ample liquidity is still available to fund both debt and equity corporate finance needs as well as consumers still confident to spend on goods and services.

Going forward, the main concern the Fed will address is the employment gap mandate, which is by all accounts expected to remain throughout all of 2022. If the FOMC takes a pass on a taper announcement on November 3rd, a December 15th announcement seems all-but-assured unless the economy completely reverses course between now and then. Tapering the balance sheet is designed to unleash the loosely-bounded influence the Fed has on long-term interest rates, but it is not equivalent to raising the Federal Funds rate, which is a real constraint on liquidity available to the banking system and is transmitted to asset prices. Currently, the market is pricing in a 100% chance of a quarter-point hike by October 2022, and the probability of equities being negatively impacted by that future event by the end of the year is relatively low. The most likely outcome for equities is an impact from the Fed taper starting sometime in the front half of 2022, at which point liquidity withdrawal will become problematic as increasing short-term interest rates comes closer to present reality. Absent an exogenous macro shock, policy error, or normal market fluctuations, it’s no surprise to see bullish market behavior representative of a supportive central bank that is still nearly a year away from withdrawing liquidity by raising interest rates.

Image Sourced from Pixabay