No surprises from the Fed

Wednesday’s FOMC meeting was the last “known” risk event for the year and it largely conformed with market expectations. While we’re cautious in overinterpreting the immediate market reaction, the positive response by risk assets to the outcome likely reflects some relief that there was no new hawkish surprise. The outcome and Fed Chair Jay Powell’s comments in the press conference on the economy are consistent with CIO’s outlook and asset allocation recommendations as we head into 2022.

What happened?

The Fed announced that it would double the pace of tapering to USD 30bn/month, with the intention to wrap up QE asset purchases by mid-March. Significant changes were made to the FOMC statement and the Summary of Economic Projections, driven by the recent high inflation data and rapid decline in the unemployment rate. In particular, the dot plot showed significantly higher expectations on rate hikes, with the median dot indicating three hikes in 2022 and another three in 2023, which is in-line with pricing in the futures market before the meeting. In his post-meeting press conference, Fed Chair Powell repeatedly noted the strength of consumer demand and the demand for labor, while also mentioning economic risks associated with the pandemic.

What is our view on Fed policy going forward?

The overall results of this meeting put the Fed firmly on a path to start raising rates next year. Their economic forecasts for 2022 include 4% GDP growth, a 3.5% unemployment rate at year-end, and inflation remaining above the 2% target throughout the year. These numbers are well above what would be needed to justify rate hikes. In line with the dot plot, we expect the Fed to raise rates toward neutral at a gradual pace not exceeding one 25 basis point hike per quarter. Risks are skewed to the upside. If inflation does not slow down in line with the Fed’s forecasts, inflation expectations rise to levels inconsistent with the 2% target, or the labor market shows signs of overheating, it could force the Fed to hike more rapidly.

What does it mean for fixed income?

With the market already pricing in a hawkish Fed, the move in longer-end Treasury yields post-meeting has been immaterial as the 10-year yield remains around 1.46%. A slight bear flattening in the yield curve—measured by the 10y-2y and 30y-5y yields—was due to the rise in the short-end of the Treasury yield curve, as the market is now pricing in close to four rate hikes in 2022, starting in mid-May.

Within fixed income, our allocation preferences continue to be predicated on the expectation that interest rates will trend higher—specifically, the 10-year yield rising a bit over 2% in the first half of 2022. Since the Fed’s pivot towards more hawkish rhetoric real yields have moved higher as break-even inflation expectations have collapsed—5-year BEI has declined from 3.20% to 2.68% since mid-November, while the 10-year fell nearly 40bps from 2.75% to 2.38%. We continue to view real yields as too low and expect them to keep grinding higher, which is why we’re cautious on sectors that are closely tied to their performance, such as TIPS. Based on these views, we continue to prefer a barbell approach, favoring senior loans and CMBS while keeping investment grade corporate bonds as least preferred because of their higher embedded interest.

What does it mean for equities?

Equity markets gyrated a bit right after the release of the Fed statement but then found their footing and moved higher, led by growth stocks. While it’s certainly possible it will take a few days for equity investors to fully digest the news from the Fed, we think the positive reaction reflects the fact that investors got what they expected. Post-meeting leadership from speculative growth stocks also suggests that some investors may have been braced for an even more hawkish pivot from the Fed. When that didn’t materialize, investors rotated back into this segment.

Overall, the news from the Fed does not change our outlook for US equities. While the Fed is accelerating the pace of stimulus withdrawal, with the Fed funds rate still near zero, monetary policy remains very accommodative. It’s unlikely that even three interest rate hikes over the next year would dent the outlook for corporate profit growth. Historically, stocks have risen after the Fed starts hiking, although the pace of gains will likely depend on the speed of the rate hikes relative to the strength of the economy. We stick with our year-end 2022 S&P 500 price target of 5,100.

What is our bottom-line advice on positioning?

The upbeat comments from Chair Powell on the US economy are consistent with our baseline view that the economic growth should remain well above trend in 2022, even as the Fed begins to tighten monetary policy. This supports our preference for equities over fixed income, with a cyclical-bias within US equities favoring value and mid-cap stocks. The USD declined about 0.5% during the press conference, but we expect additional modest dollar strength in the coming months based on diverging central bank policies between the US and other developed markets.

Co-authored with Brian Rose, Senior Economist Americas, Leslie Falconio, Senior Fixed Income Strategist, David Lefkowitz, Head of Equities Americas, and Jason Draho, Head of Asset Allocation Americas

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