A new term has now entered the vernacular – the “Powell Pivot” adding to a long list of Fed-speak that includes the “Greenspan Put” and the “taper tantrum,” among others.
Fed Chairman Powell was indeed pivoting last week as he and his fellow open market committee members dropped the term “transitory” in their statement, indicating that, just possibly, inflation is cause for concern. The announced changes to policy were a more rapid withdrawal of monetary stimulus (“tapering”), and potentially three bumps to the Fed funds rate in 2022.
That news came on Wednesday (12/15/21) and markets seemed at first to take it in stride. Stocks rose following Powell’s afternoon press conference, but the good feeling didn’t last. By Friday’s close the mood had turned decidedly negative, with all the major indexes down on the week. Yet, this week (week of 12/21/21) paints a rosier picture as the “Santa Claus rally” (another favorite Wall Street term), seems to be in full force, taking the market back to nearly its all-time high.
Investors have become accustomed to rates mostly trending down, a circumstance that has prevailed since the early days of Paul Volker, 40 years ago. The most recent increase in Fed funds took place in 2018. By one account, the last “full” cycle of increases occurred between June 2004 and June 2006 when rates rose from 1.00% to 5.25%. No one expects to see a move like that now.
But it’s not just the level that matters, it’s the direction of change, too. A market used to massive amounts of liquidity is bound to feel the strain when that liquidity starts to go away. At a minimum, volatility is likely to rise, as we have already seen. But higher rates do not necessarily portend a disaster for stocks, and three quarter point increases to the Fed funds rate would only bring it to 1.0%, still highly accommodative by historical standards.
MarketWatch columnist Mark Hulbert looked at Federal Open Market Committee (FOMC) rate increases and decreases going back to 1990 and found that, on average, stocks do better in the 12 months following an increase than they do after a rate cut. The reason for this was simple: rates were rising in response to an expanding economy. For a time at least, faster growth trumped more expensive money. (Source: MarketWatch, November 6, 2021)
Current economic data has mostly been strong but there’s a catch: it has mostly been captured prior to the latest round of Covid-driven lockdowns. Omicron, and the world’s reaction to it, have added another level of uncertainty.
Still a good year
In spite of the recent declines, we are closing in on what for equities should be a good year. Through December 22 the Dow Jones Industrial Index was up 19.7%, the S&P 500 27.6%, and the Nasdaq had returned 27.2% (Source: Bloomberg 12/22/21). Going into 2022, Omicron may dominate the headlines, but it is likely to be inflation that ultimately dictates the direction of the market.
There may be reasons to be optimistic on that score – energy costs are falling, and the supply chain bottlenecks that have bedeviled the economy will eventually be resolved, relieving some of the upward price pressure. As with the Fed funds rate, so with inflation: both direction and pace matter, and markets are likely to respond positively to a decline even if overall price levels remain elevated.
The recent behavior of the bond market suggests that investors are not yet panicking. Short-term rates are rising but the yield on 10-year treasuries has been flat or declining leading to a flattening yield curve. Real interest rates remain steeply negative and while the yield on the one-year US government “break even” bond is at 3.4%, the two-, five-, and 10-year break even yields are all lower than the one year suggesting a belief that inflation is likely to moderate in the coming months and drop off more rapidly in 2023 and beyond.
The period of near-zero interest rates was bound to come to an end at some point. The question now is how well the Fed will manage the pivot to a more normalized rate environment. We’re starting to find out.
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The Santa Claus rally refers to the tendency for the stock market to rally over the last weeks of December into the new year.
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