The Federal Reserve was so worried about not being hawkish enough that policymakers probably went too far. The Fed emerged from Wednesday’s meeting with all the guns fired: rapid 75 basis point rate hikes, more hawkish forward guidance and an unprecedented pace of balance sheet tightening. The barrage pushed Treasury yields to their highest level in more than a decade and the U.S. dollar index to a 20-year high, while sending the S&P 500 tumbling near bear market lows.
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That’s an awful lot of stress to put on the financial markets at any time. But the current global economic base looks particularly fragile as central banks struggle with inflation; Russia is waging a military war against Ukraine and an economic war against Europe; China struggles amid shutdowns and hangover from a property boom; and governments are grappling with high debt levels that have been further inflated by the pandemic.
Boxed Summer Rally in the Fed
Still, the Fed entered last week’s pivotal meeting with one goal: to negate any possible signal that would allow financial conditions to ease and the S&P 500 to rally.
By all accounts, the Fed was caught off guard by the rally in financial markets that followed its July 27 hike of 75 basis points. Building on a rally from mid-June lows, the S&P 500 had jumped 17% by mid-June. August. The 10-year Treasury yield had fallen nearly a full point over a six-week period.
Federal Reserve policymakers took umbrage at the rally, which seemed to cast doubt on their determination to control inflation. The consequence of the thaw in financial conditions this summer became all too clear with last week’s CPI report. An overly strong labor market is keeping inflation too high. While the headline inflation rate declined to 8.3%, prices for basic services, such as rent, healthcare and transport, rose 0.6% on the month and 6. 1% from a year ago, the fastest pace since February 1991.
Fixed Federal Reserve message
The summer rally began to unravel on August 26, when Fed Chief Jerome Powell, in his speech from Jackson Hole, Wyo., abandoned his earlier optimism that the U.S. economy could avoid recession. Instead, Powell signaled that the Fed would maintain tighter policy for longer, anchoring the economy so the current inflation spike doesn’t turn into a chronic 1970s-style disaster.
Powell’s speech started a market reassessment of the Fed’s policy outlook, undoing the dovish impression he had given with his July 27 press conference which had helped the S&P 500 more than halve its 24% loss, emerging from a bear market.
August’s high CPI readings shook market expectations for even higher interest rates. As a result, Wednesday’s hawkish policy signals from the Fed only confirmed the bad news that Wall Street was already expecting. A third consecutive rate hike of 75 basis points was fully priced in. Markets had already priced in a slightly greater than 50% chance that the key federal funds rate would hit a range of 4.25%-4.5% by the end of 2022 and reach 4.5%-4.75% in 2023.
No Fed put for the S&P 500 – or the global economy
So why the harsh market fallout since Wednesday’s Fed meeting? The tenor of the meeting enabled investors to no longer doubt the Fed’s determination. The markets are now waiting another 75 basis point hike November 2 and another half-point move in December. It comes as the Fed doubled the pace of balance sheet tightening to $95 billion a month, nearly double the $50 billion monthly rate that helped trigger a market meltdown and near-bear market. for the S&P 500 at the end of 2018.
At the time, inflation was too low, not too high, so Federal Reserve policy stalled. Policymakers shelved plans for a series of rate hikes to hedge against the possibility of higher inflation. Balance sheet tightening slowed and then stopped. By the fall of 2019, the Fed had started cutting rates and buying more assets. This time around, there is little hope for a reprieve from the Fed until markets get much uglier.
Perhaps the biggest problem is that the tightening is not happening in a vacuum, but is creating ripples in interconnected financial markets around the world. As Treasury yields soared after the Federal Reserve meeting, the US dollar also rose against foreign currencies. This prompted Japan to step in to support the yen for the first time since 1998. Other currencies, including the euro and the pound, are also breaking through key long-term support levels against the dollar.
When the need for the Fed to tighten its efforts to meet its domestic inflation mandate creates problems for the rest of the world, markets can quickly unravel, as they did in early 2016 and late 2018 In both cases, the Fed quickly backed away from aggressive tightening plans. . This time will be different.
The central bank of the world
The Fed is sometimes considered the central bank of the world, in part because the dollar is the world’s reserve currency and essential commodities such as oil are quoted in dollars.
While the strong dollar will help control inflation in the United States by lowering the price of imports, it will compound the problems of other countries struggling with inflation. A number of foreign central banks followed the Fed’s big hike on Wednesday with their own bigger-than-expected hikes on Thursday. But rising interest rates and weakening economies can worsen debt sustainability issues and put pressure on currencies.
On March 2, just after Russia invaded Ukraine, Powell told Congress he would support a quarter-point rate hike at the next meeting, not half a point. . “We will use our tools to strengthen financial stability,” Powell said. “We will avoid adding uncertainty to what is already an extraordinarily difficult and uncertain time.”
It is not certain that the Federal Reserve has found the right balance this week.
S&P 500 on the razor’s edge
A weak September jobs report on October 7 and a less troubling CPI reading a week later could potentially give markets a break. But next week can be a wild ride.
After slipping 9.2% over the past two weeks, the S&P 500 is now down 23% from its all-time closing high on Jan. 3 and just 0.7% above its highest. June 16 closing low. The Nasdaq composite is also near its June lows, while the Dow Jones hit a 22-month low on Friday.
Be sure to read the IBDs The big picture column after each trading day for the latest information on the current stock market trend and what it means for your trading decisions.
Please follow @IBD_JGraham on Twitter for coverage of economic policy and financial markets.
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