Markets went into a tizzy following decisions by the Federal Open Markets Committee, and Fed Chair Jerome Powell's press conference, on Wednesday. No, the FOMC did not set a date to begin tapering bond purchases, nor did it suggest that increases in interest rates are imminent.
Instead, the "dot plot" of members' intentions showed that 13 of the 18 members would like to increase rates in 2023, some of them even twice, earlier than markets had expected. Seven members wanted the hike to occur in 2022. James Bullard, President of the St. Louis Fed, added to market concerns when he went public with his view Friday that the first rate increase could come in 2022. He questioned the wisdom of continuing $40 billion monthly purchases of mortgage-backed securities despite a booming housing market.
These developments, and Powell's admission that inflation so far had been higher than the Committee had expected, set Treasury yields on a wild ride through the end of the week. The yield on 10-year obligations rose to 1.58% soon after the decision was released, but then plunged to 1.44% by close of trading Friday. The sharp fall in yield to 2.01% was even more dramatic in the case of 30-year debt. As short-dated Treasurys rose in yield reflecting new fears of a tightening, the yield curve flattened.
What was the central bank hoping to achieve with its decision, and what may be in prospect for the economy and markets during coming months?
The dot plots bringing the date of the first hike closer would mean tapering would start even earlier. This would be highly negative for equity investors dependent on an "Uncle Jay has my back" approach to investing. Not surprising that an addict would be hypersensitive to a reduction in the dosage of the drug.
Powell did try to soften the blow. He made light of the importance of FOMC members' intentions at the press conference, suggesting that "dots are not a great forecaster of future rate moves," and that markets should take those expectations with a "big grain of salt." However, he could not dismiss the accelerating inflation numbers either. So he suggested — yet again — that the inflation pickup is transitory. He must have thought that was all he could do under the circumstances.
How are Powell and his colleagues likely to act during the second half of the year, and in 2022? For this, as always, a bit of history.
Powell assumed the Chairmanship on February 1, 2018 and promptly led the central bank through four rate hikes that year. At his press conference following the meeting on December 19, he suggested that two more increases were in store for 2019. Markets cratered. Then, in an abrupt shift in messaging on January 4, 2019 — known as the "Powell Pivot" — the Chairman gave a dovish message suggesting that the Fed could be patient with rate increases. Instead of the hikes that he had warned about, the Federal Funds Rate was reduced three times in 2019. Markets were spurred upward.
Amidst these developments, it is hard to remember that the Fed's stipulated objectives are employment and low inflation, not supporting equity prices.
What of the argument that the yield spread between two- and ten-year Treasurys is narrowing and that an inversion could presage either a falling price level and / or a recession a year later? The last time the ten-year yield stayed below the two-year for several days was in late-2006, predicting the Great Recession that began in December 2007. We are nowhere near there. The ten-year was still yielding 1.19 percentage points more than the two-year at the end of last week.
A more important reason why an yield curve inversion or a recession is not in the cards, but higher inflation is, would be the likely repeat of a Powell Pivot. Should the markets continue their decline during coming days and weeks, the Fed will likely put on the benevolent uncle mantle again.
Watch Powell's appearance before a Congressional subcommittee on Tuesday for the first signs of a switch.
Komal Sri-Kumar
President, Sri-Kumar Global Strategies, Inc.
Santa Monica, California 90401