Stocks rallied yesterday after earlier setbacks as the Kremlin attempted to dial back the optimism on peace talks. Crude oil ticked higher on the discouraging news and stocks are putting the Wednesday’s rate hike in the rearview mirror.
Who’s really in charge here? Here is a little-known fact that I want to share with you. Not that you need to know this, but because I am a big Formula 1 fan and the season kicks off its 2022 season today, here it goes. Formula 1 cars hit speeds in excess of 320 kilometers per hour (200 miles per hour). Drivers maneuver their cars through corners and chicanes at almost those top speeds, rarely, if ever pressing on the brakes. How do they do that? Unimportant but interesting fact: they drive with one foot on the gas pedal and one on the brake.
Since late last year it became clear that inflation in the US was more persistent than earlier believed. The Fed had been calling it transitory, expecting it to pass without any intervention. Not only did it not pass but it, in fact, began to touch levels not seen in years. That was worrisome to the markets, but the real worries came when everyday folks, like you and me, began to feel the real effects of inflation. Markets took note and bond yields began to rise, causing volatility in the broader stock market and putting pressure on interest rate sensitive growth stocks. All at once, Chairman Powell changed gears, admitting to Congress that inflation might be a problem and that rate hikes “may be appropriate.” Of course, the admission added volatility to markets, as traders began to prepare their portfolios for a rate hiking interval.
Here we are, some 5 months after the Chairman’s testimony and the Fed just raised the key lending rate by +25 basis points. The rate hike was largely expected, but if you polled traders on the night before the announcement, most of them were expecting the markets to react negatively to the news…which it didn’t. Why did stocks rally? Remember that markets don’t like mystery and now that the Fed stayed on script, markets were free to move forward…which in this case was upward in a relief rally. Another bit of new information that came out on Wednesday was that the Fed is expecting to raise rates a total of 11 times through the end of next year. By most recent standards, that steep hiking program would be considered aggressively hawkish. Once again, the market took it in stride. Why? Because, once again, markets were expecting those hikes.
The Fed is in a tough position. Its dual mandate of ensuring low unemployment while keeping inflation in check is no easy task. Unemployment can only be low if an economy is expanding, however an expanding economy usually brings the threat of inflation. Further, low unemployment typically causes a tight labor market, which causes wages to rise. Rising wages lead to…you guessed it, inflation. Let me add another dimension. The stock market has become an important factor in consumer confidence. When markets are on the climb, confidence of all consumers (even those who don’t own stocks) rises. Strong consumer confidence is a necessary factor for economic growth. Therefore, even though market strength is not in its mandate, the Fed must always monitor it to be successful. Ready for yet another dimension? The Fed must also monitor the bond market. Fed policy has a strong influence on shorter maturities, but traders are in control of longer maturities. When traders expect rough economic conditions, longer maturity yields come down, causing the yield curve to flatten. In some cases, the yield curve turns negative which most often predates a recession.
The Fed must monitor economic conditions such as growth, employment, and inflation. It must also monitor the stock and bond markets, not to assess the health of corporations, but to gauge expectations of investors. If the Bank is able to maneuver monetary policy just right, it can achieve what it calls a soft landing, which refers to a state where the economy can grow with low inflation, low unemployment, a healthy stocks market, and a steep yield curve. The capital markets, through futures, have signaled that they expect 11 or so rate hikes through next year. The flattening treasury yield curve has signaled that the Fed should be really cautious. The Fed, with one foot on the gas and one foot on the brakes, has taken note and followed the script, successfully rounding the track. Only 56 more laps to end the race.
YESTERDAY’S MARKETS
Stocks managed to rally through tough talk from Russia and the US State Department. Relief that the first Fed hike is over with, dip buyers went shopping for beaten down growth and tech shares. The S&P500 gained +1.23%, the Dow Jones Industrial Average climbed by +1.23%, the Nasdaq Composite Index traded higher by +1.33%, the Russell 2000 Index advanced by +1.69%, and the S&P500 ESG Index notched higher by +1.16%. Bonds climbed and 10-year Treasury Note yields slipped by -1 basis point to 2.17%. Cryptos were higher by +2.0% and Bitcoin fell by -1.29%.
NXT UP