Friday's Market Minute: Equity Markets Have Yet to Throw a Tantrum

The Fed’s decision to start tapering was as well communicated as it could have been. It was fully priced in and was no surprise to those who closely follow financial markets and the economy. The Fed’s move could be aptly described as a dovish taper, in that the Fed continues to maintain a dovish stance as far as future rate hikes and inflation. Powell continues to believe the inflation we are seeing is supply-driven, won’t lead to an unabated wage-price spiral, and the Fed can still “afford to be patient.”

In the context of history, the current inflation spike will likely prove temporary, as the last 30 years of persistently low inflation without short-term surges is more of an outlier than the norm. The tweaks to the Fed’s communication on the transitory nature of inflation appeared to be constructed to appease everyone. Much like their reassurance that the tapering pace can be increased or decreased depending on the economy and inflation, they may be planning to carefully phase out ‘transitory’ language without appearing hawkish on rates.

It should be noted that U.S. Government bond markets have been quite volatile in the past two weeks as traders speculated about how quickly the central bank would taper its monthly purchases, but now appear focused on when the Federal Funds rate will begin to rise. According to the Fed Funds futures markets, there is nearly a 50% probability of a 25-basis-point rate hike in June 2022. Investors are using the bond markets to play out their central bank forecasts, but equity markets have a calm focus on generally solid earnings coming through, as well as share buybacks to keep the equity heavyweights afloat. Strong corporate earnings lifted U.S. equities by almost 7% in October, while simultaneously pushing the volatility index to a post-coronavirus crisis low of 15.

Inflation fears alone have created a precarious backdrop for such a self-confident equity market. Adding confirmation of the highly-anticipated but well-telegraphed taper from the Fed, equities are unfazed due to the patient approach the Fed signaled towards raising rates. In theory, tapering long-duration bond purchases should cause yields to rise and stocks to fall. However, $120 billion per month of purchases by the Fed is more about market psychology and less about the meaningful influence on long-term rates. We must consider that the U.S. Treasury and agency bond market has a notional value estimated at more than $46 trillion. Willing domestic and international buyers are always at the ready to fill the gap as the Fed steadily exits new balance sheet assets on the long end of the yield curve. It’s too soon to tell how equity markets over time will absorb the actionable shift the Fed announced this week, but the markets have so far clearly signaled no imminent concern for the eventual maturity mismatch (inverted yield curve) that is a developmental process of the Fed actually removing liquidity from funding markets by raising rates. Tapering the balance sheet does not remove loanable funds already circulating in the financial system, and equities got it right with a bullish reaction to the taper confirmation.