What Fed Chair Jerome Powell’s hawkish turn means for market volatility into year-end
Federal Reserve Chair Jerome Powell testifies before a Senate Banking Committee hybrid hearing on oversight of the Treasury Department and the Federal Reserve on Capitol Hill in Washington, U.S., November 30, 2021.
Elizabeth Franz | Reuters
Stocks are up again on Wednesday, but market experts were not surprised that the Dow Jones Industrial Average tested new lows on Tuesday after Monday’s brief rally, and that was even before Federal Reserve Chair Jerome Powell surprised the market with a more hawkish tone amid the new Covid threat.
Monday’s rally was not made to last: the advance/decline rate (the number of stocks within the market that went up versus down) barely broke the 50% mark, and the winners were all in tech and defensive names rather than broader sector participation. On Tuesday, Apple’s outperformance versus almost everything else in the market suggested a flight to safety among stock investors that was about as close to bond buying as the equities market gets.
The up and down action suggests the market tug of war will continue, and the Fed will now be contributing more to the volatility. So what should investors make of Powell’s hawkish messaging before the Senate, indicating the Fed will discuss accelerating its taper timeline at its mid-December meeting and that the word he has favored on inflation, “transitory” should be retired from usage?
There’s plenty of speculation about why Powell pivoted during a new Covid fear cycle. Was it because Biden announced his reappointment to the Fed chair and he feels more freedom to act? Is he getting ahead of what could be tough confirmation hearings on Capitol Hill? Could Powell be using the omicron variant as an opportunity to send a more hawkish policy message, knowing he can ultimately pull back to a more dovish tone if the Covid scientific data worsens?
What the market knows for now is that Powell’s message on inflation and the potential for an accelerated taper is more hawkish, and if the omicron threat does not turn out to be dire, Powell has moved from the center of the Fed to a position more hawkish members have been stating for months.
There is a risk that the omicron variant intensifies the supply chain issues that the global economy already is experiencing, and the related inflation, which could add pressure on the Fed to act more based on the threat of inflation than a new Covid outbreak it sees the economy as being able to handle. The Fed and Powell are on record as saying the economy has “learned” to live with Covid and each new Covid wave has done less damage to the economy.
“What we’ve seen is with successive waves of Covid over the past year and some months now, there has tended to be less in the way of economic implications from each wave,” Powell said at a press conference that came after a summer two-day meeting of the Federal Open Market Committee. “We’ve kind of learned to live with it, a lot of industries have kind of improvised their way around it,” Powell said.
In his Senate testimony this week, Powell said the omicron variant does potentially complicate the inflation threat, and inflation being sticky may continue to be the main fear of the Fed rather than omicron itself, until proven otherwise.
Experts provided CNBC with a variety of views, both positives and negatives, from Powell’s evolving position on the taper and inflation.
Fed messaging will continue to be volatility issue for stocks
What the markets are experiencing now is a preview of a period of Fed messaging that may continue to add volatility on top of the omicron situation, says David Zervos, chief market strategist at Jefferies.
Messaging for the central bank will get more difficult in his view as there are more changes in key Fed positions amid inflation concerns. And it does not help matters that it is occurring at year-end, because that’s a period of time when investors make big buying and selling decisions, whether they are up a lot in a year that still has posted a 20%-plus return for the S&P 500 and want to protect to the downside, or investors are down a lot and can’t afford to take a lot of risk.
“Friday was a preview of what happens near year ends,” Zervos said, and the Fed surprise adds another dynamic to what was already poised to be a volatile period for stocks.
Zervos says investors need to understand that a new Fed is in the process of taking shape even with Powell remaining chairman, and amid inflation and more supply side rigidities, “combining for what could be quite a bit of fireworks.”
While the Fed changes are not on the scale of a new Fed chair, the departure of Randy Quarles scheduled for year end; the resignation of Robert Kaplan of the Dallas Fed and Eric Rosengren of the Boston Fed after controversy over Fed officials trading stocks and bonds while implementing policies that influenced financial markets; and Richard Clarida’s term expiration on January 31, 2022, when he is expected to be succeeded by Lael Brainard, all will continue to create “difficult messaging issues” for the Fed, according to Zervos.
And as Powell and Brainard go to Capitol Hill for confirmation hearings and “get quizzed on everything under the sun, it’s just lots of room for miscommunication,” he said. Powell’s tough stance on Tuesday could reflect “prepping for any hard questions that might come from his hearings,” Zervos added. “We’re seeing the Fed kind of move into a bit of protection mode with the new cast of characters and where volatility could remain quite elevated.”
On inflation, he said it has been clear for some time already that the Fed’s original inflation forecast was wrong, but longer-term Powell will be proven right in the sense that inflation will come down, and rates will remain relatively low for a longer period of time, Zervos said. “But he has to look tough ahead of his boss … Congress. And that will set up room for miscommunication,” he said.
The market thinking on rate hikes hasn’t changed that much
A Fed that moves quicker on its taper isn’t necessarily a Fed that moves quicker on rate hikes, according to Tom Lee of Fundstrat Global Advisors. He says there is still a risk that omicron pushes back rate hikes and the market isn’t drawing a straight line between an accelerated taper timeline and rate hike liftoff.
The Fed may be saying that the bond buying simply isn’t helping the economy. But Lee’s view that inflation will cool in 2022 contributes to a belief that central bank policy on the taper will be separate from its rate hike trajectory.
“Powell is catching up to Fed members and acknowledging we won’t see a peak in inflationary pressures in the next month or so, but I don’t think that means we are intractably setting up for higher levels of inflation,” Lee said.
A quicker taper pace could mean it ends by April or May, but the CME FedWatch Tool has declined over the past week in its expectation of a hike in May 2022 from 43% to 40%, and Lee noted the Fed rate forecasting data he watches has not moved in a way that makes him think the rate outlook has changed in any significant way.
The economy can handle a more hawkish Fed
Bruce Kasman, JPMorgan’s head of global economic research and chief economist, said amid the Fed shift in tone investors should keep in mind that the economy is showing strength this quarter, even though the omicron uncertainty adds a new threat and inflation remains persistent.
Powell’s tone follows a “steady stream of Fed speakers” saying the taper should accelerate and the market can’t rule out a Fed that moves earlier on rates sometime next year, but part of the story behind a more hawkish Fed is the underlying health and resiliency of the U.S. economy.
“The Fed is moving because the economy can handle it,” Kasman said.
The omicron wildcard remains impossible to factor into the economy outlook, but what the economy is showing right now is “an enormous amount of health in the private sector and pent up demand,” he said. “I think what they [the Fed] will do here is more than people expect but quite reasonable for keeping this economy on solid ground,” he added.
The overall environment is setting up for a longer period of expansion, and for investors in equities and risk assets, the most important factor is whether the economy can stay on a recovery path for a long period of time, and a Fed that raises rates a little earlier doesn’t stop that momentum but does introduce more volatility in the short-term.
“I would argue the Fed moving earlier and recognizing how this expansion is very different than the last one and will require higher rates … is a good signal, but the market needs to digest it,” Kasman said.
Still a wide range of interest rate possibilities
Whether omicron or the Fed, the next few months will include “a wide range of possibilities,” says Meghan Shue, Wilmington Trust Investment Advisors’ head of investment strategy.
She views “increased optionality” for the Fed on its taper timeline as a good thing for the markets, and she noted there already has been a “loud chorus on acceleration of the taper” from within the Fed.
An earlier end to the taper is more likely to mean an earlier liftoff for rates, in her view, but if that is the implication Powell intended in his new message, it is the trajectory of the rate hikes rather than the date of liftoff that will matter the most, Shue said.
“If it ends up being an earlier start to hiking rates but a shallower rate hike cycle, that’s a better outcome for the market,” she said. “An earlier start to rate liftoff doesn’t mean aggressive hiking. That is an environment in which the market can continue to do well.”
But for now, the market’s attempt to digest a wider range of possibilities, both in terms of the potential for more Covid cases and a more hawkish Fed, will add to volatility.
Powell’s timing is curious, but inflation message overdue
Inflation has to be taken more seriously by the Fed, according to Mohamed El-Erian, chief economic adviser of Allianz and former CEO of PIMCO, and the implications for the taper should have been communicated months ago.
The fact that Powell chose this moment as the market is trying to understand what the omicron variant of Covid means “is curious,” he said. “I wouldn’t have chosen it, but is about time we moved onto a more realistic assessment of inflation and more responsive monetary policy,” he added.
El-Erian said central banks around the world can’t fix the supply chain or labor shortages, but what they can do is minimize the risk to the economy from inflation amid mounting evidence that inflation is becoming “de-anchored” from expectations.
The problem all along has been the problem of potentially waiting too long, he said, and the omicron variant has added to that risk.
“Waiting too long you end up in a lose-lose situation,” El-Erian said.
He expressed disappointment that Powell didn’t take advantage of a “massive window” to implement a more hawkish policy earlier this year amid a strong economy and record stock market, and as the Covid situation improved, too.
“Inflation is the biggest threat to investors,” he said.
Market already expected more Fed volatility
Even before the latest variant hit, the view from Truist co-chief investment officer and chief market strategist Keith Lerner was that the uncertainty around the pace of Fed tightening and inflationary concerns would inject higher volatility into the market relative to what investors saw for most of this past year, but would not stop the equities bull market in 2022.
“The comments from Powell complicate the near-term story,” he said in an email to CNBC, but he added, “while Powell indicated that it is appropriate to consider wrapping the taper more quickly, he didn’t define the criteria for that to be met. And if we see a greater market decline or if there are signs that the omicron variant is slowing economic activity, there is a strong likelihood that the Fed’s language becomes more dovish.”
Lerner says it is instructive to look back at Powell’s 2018, when investors were concerned that the Fed was on autopilot, which caused a sharp decline in the market around the holidays.
“Learning from that experience, we believe that if need be, he’ll pivot,” Lerner wrote.
He too believes there is no escaping the volatility in the interim, though.
“The Fed, just like the market, is waiting to get more clarity on omicron. And until there is clarity and knowing that the Fed is staying firm in their stance, at least for today, that’s going to weigh on sentiment and markets are set to be headline driven and choppy.”
He remains bullish on stocks in 2022 based on the view that corporations and consumers have adapted, that pent-up demand remains, and that the economy remains on solid footing. “We still see the primary market trend as higher, but it will likely continue to be a rocky near-term road.”