Defiant Bulls Stand Up To Fed With Trillion-Dollar Stock Rally
In the eight days since, they’ve watched the rallying S&P 500 Index create more than $1 trillion in fresh investor wealth.
(Bloomberg) -- Federal Reserve policy makers put markets on notice in their last meeting minutes. Runups in risky assets were a concern, fueling an “unwarranted easing in financial conditions” that bedeviled their efforts to cool inflation.
In the eight days since, they’ve watched the rallying S&P 500 Index create more than $1 trillion in fresh investor wealth. Gains picked up speed this week with the gauge climbing in four of the five sessions, leaving it up more than 4% for the year.
Debates about the inflationary impact of ever-buoyant stock and bond markets have moved from nerdy obsession to one of the bigger issues facing the Fed — even as evidence builds that price pressures have peaked elsewhere in the economy. While readings on consumer costs have cooled after 425 basis points of interest-rate hikes, financial conditions — a measure of strain across asset classes — are at looser levels than before the Fed’s liftoff last March, according to a Bloomberg gauge.
That’s potentially a problem for central bankers attempting to take the edge off economic growth, given markets are part of the mechanism through which monetary policy touches the real economy. The anxiety was on display in last week’s Fed minutes, in which policymakers said easing financial conditions could snarl their efforts, particularly if it were driven by “a misperception by the public of the committee’s reaction function.”
That’s Fedspeak for traders betting on a premature end to the most aggressive tightening campaign in modern history.
“The Fed is worried that easier financial conditions will delay further the move in inflation back to 2%,” Apollo Global Management chief economist Torsten Slok, wrote in a report. That “leaves the Fed with no other options than to continue to be hawkish, and this continued hawkishness is limiting how much equity and credit markets can rally over the coming months.”
Despite near-constant pushback from Fed members, optimism that a pause is in the offing has fueled twin rallies in stocks and bonds over the past few months, loosening financial conditions and threatening to whip up a feedback loop that keeps the central bank hawkish.
Data released Thursday showed that consumer prices climbed 6.5% in the 12 months through December, the slowest pace of inflation in a year. Stocks rose and yields on two-year Treasuries dropped Thursday as consensus solidified that the Fed will raise rates by just 25 basis points at next month’s meeting, and may skip a hike altogether in March.
This week’s gains added steam to a rally that’s been building since the S&P 500’s mid-October’s low. Bonds have climbed as well, with 10-year Treasury yields dropping from 15-year highs and credit spreads tightening, while the dollar has eased from its peaks as well. Taken together, that’s served to loosen financial conditions over the past three months from the most restrictive levels in a decade, Bloomberg data show.
Beyond just a collection of market moves, financial conditions are the “most observable translation” of monetary policy into real-world impacts, according to Ian Lyngen of BMO Capital Markets. A higher cost of funding feeds into corporate decisions and leverage levels, while rising asset prices means that the wealth effect could lead consumers to spend more — keeping inflationary pressures on the boil.
“Our biggest concern, and we suspect that it’s one shared by the Fed, is that as equity prices stabilize and edge a bit higher, we’ll see a decline in realized volatility, which subsequently will ease financial conditions,” BMO rates strategist Lyngen said on the firm’s Macro Horizons podcast. “Easier financial conditions in an environment where the Fed’s stated objective is to tighten financial conditions and keep them tight for an extended period of time will complicate Powell’s job, to put it mildly.”
Traders appear to be brushing off that possibility. Swaps markets show that investors anticipate that the Fed’s rate will peak around 4.9%, while the central bank’s own projections have penciled in a destination above 5%. And while policymakers have indicated they plan to hold rates at that level through the end of 2023, roughly a half point of cuts are priced in for the second half of this year.
To Priya Misra of TD Securities, the conversation around the easing in financial conditions misses an operative word from the Fed’s December minutes — “unwarranted.” If risk assets are rallying and thus loosening conditions because investors are anticipating a more dovish Fed, that’s problematic to policymakers, she said. But if risk appetite is rising because key risks are dissipating, that doesn’t necessarily work against their goals.
“Financial conditions have to tighten for hikes to work through the economy and slow things down,” said Misra, TD’s global head of rates strategy. “But if financial conditions have eased because some tail risks have declined — China Zero-Covid or inflation accelerating, which forces the Fed to keep hiking — then the Fed might not have an issue with it.”
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