That would be quite a shift from September. The last set of projections showed nine of 18 Federal Reserve policymakers thought it would make sense to wait until 2023 for the cycle’s first rate hike. Still, there’s some chance that the Fed could deliver an even more hawkish, negative surprise for the stock market.
Federal Reserve Taper Precedes Rate Hikes
On Nov. 3, the Federal Reserve announced it would slow crisis-driven asset purchases from the $120 billion monthly pace. The initial steps down of $15 billion per month would have purchases of Treasuries and mortgage securities wrap up by June.
But on Nov. 30, Fed chief Jerome Powell told Congress that policymakers would consider wrapping up asset purchases “a few months sooner.” Several other Fed officials signaled their support and openness to a faster bond taper at the December Fed meeting
Now Wall Street economists expect policymakers to curb asset purchases by $30 billion per month at the December Fed meeting, falling to zero in March.
That timing is significant because the Fed has long signaled it would hold its key interest rate steady until after it halts its nonconventional balance-sheet expansion. That means interest-rate hikes could be on the table as early as March.
Powell’s signal of a faster Fed taper had one big caveat: If the omicron variant proves to be virulent, all bets could be off. Yet as early evidence showed the omicron variant appears relatively mild, the stock market took off last week.
The implication: Even though Fed asset purchases are often seen as fuel for higher stock prices, stock market investors aren’t especially worried about a faster taper.
Still, the rapid spread of the omicron variant in the U.K. could give enough policymakers pause to produce a less-hawkish set of rate-hike projections. Stock prices and Treasury yields fell solidly Monday, led by travel-related stocks, on U.K.-led omicron fears.
As of Monday afternoon, CME Group showed 57% odds of three Fed rate hikes by December 2022.
Fed Mandates: One Down, One To Go
In previous cycles, the Federal Reserve began hiking its key interest rate preemptively, to keep the economy from overheating. But in 2019, the Fed concluded it had acted prematurely, slowing down the economy and job growth, even though inflation remained below target.
The Fed’s big policy shift in August 2020 featured two big changes. The Fed would no longer hike its benchmark rate before the labor market achieved full employment. Even then, the Fed wouldn’t hike unless inflation had run moderately above the 2% target for a period of time.
The latter of those tests has been met, Powell indicated to Congress recently. In November, the inflation rate hit a 39-year-high 6.8%, based on the consumer price index.
“The threat of persistently higher inflation has grown,” Powell said, dropping his earlier characterization of inflation as transitory. “It’s a good time to retire that word.”
That leaves the loosely defined criteria of full employment as the only remaining hurdle to rate hikes.
How Close Is Full Employment?
The labor force — everyone either working or actively seeking a job — is down by 2.4 million since February 2020. That’s despite the working-age population (16 and up) growing by 2.4 million over the same period.
But there’s less labor market slack than meets the eye, because the senior population has ballooned by 3 million as the oldest baby boomers turn 75.
Labor force participation typically drops to about one in five among older workers. Covid-related risk and a boom in the stock market and real estate wealth may be giving older Americans more reasons to retire or stay retired.
A range of data shows that the labor market is already very tight. In September, Fed projections had the 5.2% unemployment rate easing to 4.8% in the fourth quarter. Instead, unemployment has plunged a full point to 4.2%. New claims for jobless benefits have tumbled to levels last seen in 1969. Plus, October data showed that the number of job seekers had fallen to 67 per 100 openings, 18% below pre-Covid levels.
Powell has stressed that the Fed will consider inclusive measures, such as minority unemployment, to gauge full employment. Yet strong wage growth among relatively modest wage earners already meets the test.
Prime-age (25-54) employment is still about 1.9 million below pre-Covid levels. The key question is how fast that job deficit will be erased. If it happens over the next six months, the Fed will have no reason to pass on a June 2022 quarter-point rate hike.
Fed Rate Hikes And The Stock Market
A June move would open the door to three rate hikes in 2022, with subsequent moves in September and December. Even so, monetary policy would remain highly accommodative, with the Fed’s benchmark potentially rising to a range of 0.75%-1%, well below the rate of inflation.
Still, if Fed projections pencil in a third rate hike, that would constitute a negative surprise for the stock market. The impact would likely vary by sector.
Recent Fed hawkishness has pushed up short-term Treasury yields, while long-term Treasury yields have fallen. Investors seem to think that the Fed may act too aggressively, which will have longer-term disinflationary effects.
The flattening Treasury yield curve helps explain why bank stocks have struggled lately, while the overall stock market — and especially tech stocks — has fared better. Since banks borrow at short rates and lend at long rates, their net interest margins are squeezed when the yield curve flattens.
Meanwhile, growth-stock valuations tend to be helped by a lower 10-year Treasury yield, which is used to discount future earnings back to the present.
Whither The Fed Balance Sheet?
There’s also another risk that stock market investors need to look out for, though it’s probably not a clear and present danger.
At issue is what the Fed will do with the extra $4.5 trillion in assets on its balance sheet once the taper is complete. As those Treasury and mortgage securities mature, the Fed faces a choice of whether to let its balance sheet shrink or to roll over the principal, as well as interest, into new purchases.
Last month, St. Louis Fed President James Bullard said he’d like to see the Fed “allow runoff of the balance sheet at the end of the taper or shortly thereafter.” Bullard will be a voting policy member in 2022.
Yet the stock market might not react well to any inkling that the Fed is considering this idea. The last time the Fed shrank its balance sheet amid interest-rate hikes, the stock market had a bear-market scare in late 2018. That forced the Fed to call it off and resume balance sheet growth in 2019.
Allowing the balance sheet to run off “might also allow the Fed to address inflation concerns without hiking rates prematurely,” wrote Aneta Markowska, chief economist at Jefferies. “It would also allow the Fed to tighten conditions in a way that does not put as much (upward) pressure on the dollar.”
Markowska says that any mention by Powell that an early runoff of the balance sheet is under consideration might steepen the Treasury yield curve. That might be good for bank stocks, if not for the overall stock market.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.