Fed Meeting: What Double-Fisted Tightening Means For Stock Market

The Federal Reserve on Wednesday said it will finish winding down crisis-driven asset purchases before its mid-March meeting, likely just in time for the first rate hike of the cycle. The 2 p.m. ET policy announcement largely tracked with Wall Street's expectations. With investors on edge for a hawkish surprise, the stock market initially extended Wednesday's already-strong gains. But the rally faltered during Fed chief Jerome Powell's press conference as short-term government bond yields jumped.

The Fed said that a rise in the 0%-0.25% benchmark rate “will soon be appropriate,” with inflation running well above target and the labor market approaching maximum employment. That indicates the initial quarter-point rate-hike of the cycle will come at the next Fed meeting, March 15-16.

Asset purchases, which are running at a $60-billion monthly pace, will ratchet down to $30 billion in February and come to a halt in early March.

Some on Wall Street figured the Fed might halt asset purchases a month earlier, which would have signaled an even greater degree of urgency. Still, the Fed is about to execute a sharp U-turn in policy, from asset purchases to rate hikes to shrinking the balance sheet.

The stock market began to come unglued on Jan. 5, when published minutes from the December meeting revealed a consensus that the Fed should begin reversing $4.5 trillion in Covid-era asset purchases sooner and faster than investors had anticipated.

“There's a substantial amount of shrinkage in the balance sheet to be done,” Powell said in his press conference.

He said his guess is that the Fed will discuss balance-sheet policy for at least the next two meetings before announcing its plan. That would mean an announcement about starting to gradually shrink the balance sheet as bond holdings mature could come as soon as the June 14-15 meeting.

Powell also indicated he sees the labor market as essentially having achieved maximum employment, noting “very large wage increases.” While nothing he said was at all surprising, nothing he said was all that reassuring.

The need to position policy to address the risk that high inflation will be more persistent is what is troubling the stock market. Policy has a long way to tighten.

Stock Market Reaction To Fed Meeting

After the Fed meeting, the stock market initially extending healthy gains from earlier in the trading day, then reversed lower into negative territory as Powell spoke.

The Dow Jones industrial average fell 0.4%, while the S&P 500 lost 0.15%. The Nasdaq composite, which had borne the brunt of Fed fears to start the year, rose as much as 3% on the session, but turned negative as Powell spoke, before closing just above break-even.

After the Fed policy news, the 10-year Treasury yield rose about 7 basis points to 1.85%. However, the 2-year Treasury yield jumped about 13 basis points to 1.15%.

The CME Group's FedWatch tool indicated markets now see nearly 50% odds of five quarter-point rate hikes this year, up from about 33% odds.

Make sure to read IBD's daily afternoon The Big Picture column to get the latest on the prevailing stock market trend and what it means for your trading decisions.

Double-Fisted Tightening On The Way

The stock market fell into correction this month amid a realization that the Fed is way behind the curve and will resort to double-fisted tightening to try and regain control of inflation.

The Fed has its work cut out for it to shift monetary policy from being wildly accommodative to something close to neutral. That means policymakers will tighten with both fists — hiking the federal funds rate and shrinking the balance sheet. And they'll likely want to keep at it for a while, despite any modest softening of economic data. The main risk now, in most policymakers' view, is that inflation will continue to run too hot amid easy financial conditions. If that happens, the Fed would be forced to tighten even more aggressively. That's the typical recipe for a recession.

Deutsche Bank economists are expecting the Fed to start small over the summer but ramp up balance-sheet reduction to $105 billion per month by December. These economists figure that $1.5 trillion in assets would run off the balance sheet by the end of 2023, roughly equivalent to between 2.5 and 3.5 quarter-point rate hikes.

When the Federal Reserve last combined rate hikes with balance-sheet tightening, the stock market tanked in the fall of 2018, flirting with bear-market territory. Eventually, policymakers signaled retreat in early 2019, as rate hikes turned to rate cuts and the Fed renewed bond purchases.

“In dealing with balance sheet issues, we've learned that it's best to take a careful sort of methodical approach,” Fed chief Jerome Powell said at his Dec. 15 news conference. “Markets can be sensitive to it.”

However, it was a pretty simple matter for the Fed to backpedal in early 2019 because inflation was tame.

Originally published on Investors.com