The Fed Sharpens its Axe
Last year’s jubilance was met with uncertainty after the Federal Reserve signaled it may take a more aggressive stance to slow inflation. An outsized loss in the tech-heavy NASDAQ highlighted that faster-growing tech stocks are more susceptible to selling if the Fed moves to raise rates at a faster pace.
On Wednesday, the Fed released the minutes from its December meeting, which reflected a more hawkish tone than many investors had expected. Before we touch on the high points, let’s acknowledge that talk about the minutes is usually left to economists. It’s a wonky topic. But it influenced action last week.
That said, the minutes are simply a discussion among central bankers about the economy and a possible path of future policy. It’s a signal, but it’s not set in concrete.
Key points from the minutes—
- A hike in the fed funds rate may occur “sooner or at a faster pace than participants had earlier anticipated.” In other words, investors took this as a sign that the Fed could raise the fed funds rate as soon as March, when its bond buying program is scheduled to end.
Last month, May or June seemed more likely. In addition, we could see four, ¼% rate hikes this year instead of three, which was projected at the December meeting.
A key gauge from the CME Group suggests as much: up to four rate hikes starting in March.
2. What surprised most investors was a remark that the Fed may be preparing to reduce some of the assets it loaded up on when the pandemic began. Buying bonds injects cash into the financial system. Letting maturing bonds runoff without replacing them removes cash.
I recognize any talk about the Fed’s asset mix is also detailed and wonky, but bear with me, as it affected trading last week.
Prior to the 2008 financial crisis, assets held by the Fed were primarily short-term T-bills. During and after the crisis, the Fed began what was popularly called QE, or quantitative easing—the purchase of longer-term Treasury bonds and mortgage-backed securities.
We saw a gradual runoff that began in 2018 and ended in 2019. But the pandemic encouraged new buying, and assets more than doubled to almost $9 trillion.
Last month, the Fed had high-level talks about allowing maturing bonds to runoff its balance sheet without replacing them. Such a policy shift would help address inflation.
No timeframe was forthcoming, but there were comments in the minutes that it might begin soon after any liftoff in rates.
Taking cash out of the financial system would be a more aggressive response. And shorter-term investors responded by sending most stocks lower.
Additionally, we saw a jump in Treasury bond yields last week—see table of returns. Despite high inflation last year, yields had remained surprisingly calm.
Yet, as the market attempts to find a new normal, today’s growing economy remains a tailwind for stocks, helping to cushion last week’s decline.
