The Federal Reserve was so concerned about not being tight enough that policymakers probably overdid it. The Fed emerged from Wednesday’s meeting with guns blazing: rapid rate hikes of 75 basis points, more restrictive forward guidance and an unprecedented pace of balance sheet tightening. The barrage has pushed Treasury yields to their highest levels in more than a decade and the US Dollar Index to a 20-year high, while the S&P 500 plunged near bear-market lows.
That’s a lot of stress to put on the financial markets at any time. But the current global economic fundamentals appear particularly fragile as central banks battle inflation; Russia is waging a military war against Ukraine and an economic war against Europe; China grapples with lockdowns and a hangover from a housing boom; and governments are saddled with heavy debt burdens that have been further inflated by the pandemic.
Summer Rally Boxed In The Fed
Still, the Fed entered last week’s crucial meeting with one goal: to quash any possible signal that would allow fiscal easing and a recovery in the S&P 500.
By all accounts, the Fed was caught off guard by the financial market rally that followed its 75 basis point hike on July 27th. Building on a rally from the mid-June lows, the S&P 500 was up 17% by mid-June. August. The 10-year Treasury yield had declined nearly a full point over a six-week period.
Federal Reserve policymakers took offense at this rally, which appeared to cast doubt on their resolve to tame inflation. The fallout from this summer’s thawed financial conditions was all too clear with last week’s CPI report. A labor market that is far too strong is still keeping inflation far too high. While the headline inflation rate fell to 8.3%, prices for core services such as rent, healthcare and transportation rose 0.6% month-on-month and 6.1% year-on-year, the fastest pace since February 1991.
Federal Reserve news correction
The summer rally began on August 26 when Fed Chair Jerome Powell ditched earlier optimism that the US economy could avoid a recession in his speech in Jackson Hole, Wyoming. Instead, Powell signaled that the Fed would keep policies tighter and the economy grounded for longer lest the current inflationary spree turn into a chronic 1970s-style catastrophe.
Powell’s speech ushered in a reassessment of the Fed’s monetary policy outlook, reversing the dovish impression he made at his July 27 news conference, which had helped the S&P 500 cut its 24% loss by more than half and one exit bear market.
August’s hot CPI read pushed market interest rate expectations even higher. As a result, most of the Fed’s dovish monetary policy signals on Wednesday merely confirmed the bad news that Wall Street had already anticipated. A third straight rate hike of 75 basis points was fully priced in. Markets had already priced in just over 50% chances that the federal funds rate would rise to a range of 4.25%-4.5% by the end of 2022, reaching 4.5%-4.75% a year 2023
No Fed put on the S&P 500 – or the global economy
So why the harsh fallout for markets since Wednesday’s Fed meeting? The tone of the meeting ensured that investors will not doubt the Fed’s resolve again. Markets are now expecting another 75 basis point hike on November 2nd and another half point hike in December. That comes as the Fed has doubled the pace of balance sheet tightening to as much as $95 billion a month — nearly double the $50 billion monthly rate that helped fuel a market slump and bear market in late 2018 trigger for the S&P 500.
Back then, inflation was too low, not too high, so Federal Reserve policy was about a dime. Policymakers shelved their plan for a series of rate hikes to protect themselves from possible higher inflation. The balance sheet tightening slowed and then stopped. In the fall of 2019, the Fed began cutting interest rates and buying more assets. This time around there is little hope of Fed respite until markets get a lot uglier.
The bigger problem may be that the tightening is not taking place in a vacuum, but is making ripples in interconnected financial markets around the world. As Treasury yields soared after the Federal Reserve meeting, so did the US dollar against foreign currencies. This provoked Japan to intervene to support the yen for the first time since 1998. Other currencies including the euro and sterling are also breaking key long-term support levels against the dollar.
When the need for the Fed to tighten to meet its domestic inflationary mandate creates problems for the rest of the world, markets can quickly become unnerved, as they did in early 2016 and late 2018. In both cases, the Fed quickly turned away from aggressive tightening plans. It will be different this time.
The Central Bank of the World
The Fed is sometimes considered the world’s central bank, in part because the dollar is the world’s reserve currency and major commodities like oil are priced in dollars.
While the strong dollar will help tame US inflation by lowering import prices, it will exacerbate problems for other countries struggling with inflation. A number of foreign central banks followed the Fed’s big rate hike on Wednesday with their own larger-than-expected rate hikes on Thursday. But raising interest rates and weakening their economies can exacerbate debt sustainability problems and put currencies under pressure.
Back on March 2, shortly after Russia’s invasion of Ukraine, Powell told Congress he would support a quarter-point rate hike at the upcoming session, not a half-point. “We will use our tools to contribute to financial stability,” Powell said. “We will avoid adding uncertainty to an already extraordinarily challenging and uncertain moment.”
It’s not clear if the Federal Reserve struck the right balance this week.
S&P 500 on a knife edge
A weak September jobs report on October 7th and a less worrying CPI reading a week later could potentially give markets some respite. But next week could be a wild ride.
After falling 9.2% over the past two weeks, the S&P 500 is now 23% below its all-time closing high of Jan. 3 and just 0.7% above its closing low of June 16. The Nasdaq Composite is also close to its June lows, while the Dow Jones hit a 22-month low on Friday.
Be sure to read the IBD column, The Big Picture, after each trading day for the latest on the prevailing 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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