Is the Fed Prepping Markets For Some Tapering?

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Jeff Cox of CNBC reports that Federal Reserve Chairman Jerome Powell sees taper by the end of the year, but says there’s ‘much ground to cover’ before rate hikes:

Federal Reserve Chairman Jerome Powell indicated Friday that the central bank is likely to begin withdrawing some of its easy-money policies before the end of the year, though he still sees interest rate hikes off in the distance.

In a much-anticipated speech as part of the Fed’s annual Jackson Hole, Wyoming, symposium, Powell said the economy has reached a point where it no longer needs as much policy support.

That means the Fed likely will begin cutting the amount of bonds it buys each month before the end of the year, so long as economic progress continues. Based on statements from other central bank officials, a tapering announcement could come as soon as the Fed’s Sept. 21-22 meeting.

However, it does not mean that rate increases are looming.

“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” Powell said in prepared remarks for the virtual summit.

He added that while inflation is solidly around the Fed’s 2% target rate, “we have much ground to cover to reach maximum employment,” which is the second prong of the central bank’s dual mandate and necessary before rate hikes happen.

Markets reacted positively to Powell’s comments, sending major stock indexes to record highs while government bond yields moved lower.

Later in the day, Fed Vice Chairman Richard Clarida said he agrees with Powell’s remarks and expects tapering to being this year so long as the pace of labor gains continues, though neither official set a specific date for when the process will begin.

“I think that if that materializes, then I would support commencing a reduction in the pace of our purchases later this year,” Clarida told CNBC.

Powell also devoted an extensive passage in the speech to explaining why he continues to think the current inflation rise is transitory and will drop eventually to the target level.

The Fed has used the term “substantial further progress” as a benchmark for when it will start tightening policy. Powell said that “test has been met” for inflation while there “has also been clear progress toward maximum employment.” He said he and his fellow officials agreed at the July Federal Open Market Committee meeting that “it could be appropriate to start reducing the pace of asset purchases this year.”

That question over “tapering” of the minimum $120 billion of monthly bond purchases has had the market’s attention as much for what it means on a mechanical level as for what it signifies when the Fed will start hiking rates.

In an effort to resuscitate the economy during the early days of the Covid-19 pandemic, the Fed took its benchmark rate down to near zero and accelerated its bond buying, or quantitative easing, program to where its balance sheet is now at nearly $8.4 trillion, about double where it was in March 2020.

At last year’s Jackson Hole summit, also held virtually, Powell outlined a bold new policy initiative in which the Fed committed to full and inclusive employment even if it meant allowing inflation to run hot for a while. Critics have charged that the policy is partially to blame for current price pressures at their highest levels in about 30 years.

However, Powell defended the policy Friday and stressed the importance of the Fed not making an “ill-timed policy move” in response to temporary economic gyrations like the action this year in inflation.

“Today, with substantial slack remaining in the labor market and the pandemic continuing, such a mistake could be particularly harmful,” he said. “We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy.”

The unemployment rate for July stood at 5.4%, down from the April 2020 high of 14.8% but still reflective of a jobs market that remains well off where it stood before the pandemic. In February 2020, unemployment was 3.5% and there were 6 million more Americans working and 3 million more considered in the labor force.

Powell noted that the delta variant of Covid “presents a near-term risk” to getting back to full employment, but he insisted that “the prospects are good for continued progress toward maximum employment.”

He added that some of the factors that pushed inflation higher are starting to abate, though several regional Fed presidents have told CNBC in recent days that they see lasting pressures in their districts.

“Inflation at these levels is, of course, a cause for concern. But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary,” he said.

Alright, it was a long week where everyone was waiting to see what Federal Reserve Chairman Jerome Powell (JPow) will say at the annual Jackson Hole symposium.

And quite predictably, JPow didn't disappoint the power elite -- wealthy hedge fund and private equity managers, tech moguls, corporate titans and uber-wealthy families -- by basically stating more of the same, they aren't too concerned about inflation and won't taper until employment gains pick up to pre-pandemic levels (or closer to them).

The Fed's balance sheet is now $8.4 trillion, about double where it was March 2020.

All that liquidity is making wealthy asset owners even more wealthy and yes, its’s helping retail investors too as they are seeing their 401(k) balances rise.

But let's call a spade a spade: the pandemic and massive monetary and fiscal stimulus to respond to it has been a boon for billionaires, not the restless masses who are worried about the where their next paycheck is coming from or retirees who can't lock in high rates to retire in dignity.

The Fed can say what it wants but it has exacerbated wealth inequality to levels we haven't seen in decades and this will only create more social tensions and cause new geopolitical risks as populism takes over.

Still, JPow doesn't want a depression on his watch so he will continue doing what his predecessors have done, keep rates at ultra-low levels and juice markets through massive asset purchase program, and continue pandering to the power elite (watch George Carlin's skit on "The American Dream," nothing has changed, it's only getting worse).

Don't get me wrong, I don't blame JPow, I'd probably do the same thing, choose the path of least resistance, don't stir a hornet's nest when the waters are calm.

There is a problem, however, with maintaining the status quo.

An inflation measure the Federal Reserve uses to set policy rose 3.6% in July from a year ago, meeting Wall Street expectations but also tying the highest level in about 30 years:

The core personal consumption expenditures price index, which the Fed sees as the broadest measure of inflation, was unchanged from June, which was revised up one-tenth of a percentage point, the Commerce Department reported Friday. That 3.6% reading equaled the Dow Jones estimate and appeared to be the highest level since May 1991.

Including volatile food and energy prices, the index rose 4.2% year over year, up from 4% in June and the highest reading since January 1991.

JPow and company are hoping inflation has peaked or is peaking here because if it's not, that presents a big problem for them.

The longer they wait to taper and raise rates, especially if inflation remains sticky, the worse off they will be because they then run the risk of stoking further inflation and will be forced to hike rates much more aggressively.

I'm not saying inflation is sticky, I'm also more in the transient camp, but I think it's important to pay attention to any potential spillover into wages, something we have yet to see. 

There's another problem with inflation. The great economist, Milton Friedman, once observed "inflation is taxation without legislation" and it disproportionately hurts the poor and working poor.

In other words, if the Fed isn't careful, it runs the risk of further exacerbating rising inequality, more than it has already done.

As far as stocks, the major averages finished the week higher after Powell prepares markets for Fed’s bond taper this year:

Stocks rose on Friday heading for a winning week as Federal Reserve Chairman Jerome Powell prepared the markets for the central bank to pull back on some of its monetary stimulus, saying it’s likely to start tapering its $120 billion in monthly bond purchases this year.

The Dow Jones Industrial Average gained 242.68 points, or 0.6%, to 35,455.80. The S&P 500 rose 0.8% to hit a new high and closed at 4,509.37. The Nasdaq Composite added 1.2%, also hitting a new record during the session, closing at 15,129.50.

The three major stock averages closed the week in the green. The Dow finished up 0.9%, while the S&P 500 added 1.5% and the Nasdaq Composite gained 2.8%.

The 10-year Treasury yield, which ran up this week into the Powell speech, eased slightly after the Fed chief’s remarks as he made clear that interest rate hikes would not immediately follow after tapering was over.

“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” Powell said.

Powell also said inflation is solidly around the central bank’s 2% target rate, one of the goals of the Fed’s dual mandate. It has “much ground to cover” to reach its other goal of maximum employment, however, though there has “been clear progress” toward it, Powell added. The Fed has used the term “substantial further progress” as a benchmark for when it will start tightening policy.

Based on statements from other central bank officials, a tapering announcement could come as soon as the Fed’s Sept. 21-22 meeting.

The financial markets’ reaction Friday is a sign that the central bank has successfully prepped investors so far for a removal of its $120 billion a month in bond buying and may avoid a “taper tantrum” like the one that rocked markets temporarily at the end of 2013. Markets seem relieved the Fed isn’t planning to raise rates soon, said Michael Arone, chief investment strategist for the US SPDR Business at State Street Global Advisors.

“Interest rate hikes are far, far away, and investors are happy about that,” he said. “I think Powell deserves some credit for navigating the tapering of assets, avoiding a tantrum. The market seems well prepared for the start of tapering.”

The speech also signaled the Fed isn’t nearly as nervous about prices as some in the market and Washington are, said Adam Crisafulli, founder of Vital Knowledge.

“Powell spends the bulk of the speech pushing back on inflation concerns,” he said of the speech, adding that the Fed chairman “pushes back on rate liftoff worries, telling markets that the threshold for rate hikes is much higher than tapering.” 

Cliff Hodge, chief investment officer for Cornerstone Wealth, noted that Powell remained firm in the Fed’s view that elevated inflation is transitory, despite the Commerce Department earlier Friday reporting the largest year-over-year personal consumption expenditures increase since 1991. The PCE Index rose 4.2% in July from the same time last year and 0.4% from the previous month.

“He successfully threaded the needle in communicating that tapering will likely begin this year, while reinforcing the notion that tapering does not mean tightening,” Hodge said. “We believe that barring further setbacks from the delta variant, that September will likely produce a blowout jobs number and set the table for the official tapering announcement at the September FOMC meeting.”

Energy stocks led the S&P 500, after being among the hardest hit on Thursday. Occidental Petroleum climbed 6.9%, Cimarex Energy rose 6.5% and APA Corp rose 5.9%.

Automakers got a boost with Ford and General Motors rising 3% and 2%, respectively. Travel stocks, including air carriers, cruise lines and hotels were lifted as well. The Invesco Dynamic Leisure and Entertainment ETF gained 2.27%.

Shares of Workday surged 9.1% after reporting strong currently earnings and subscription revenue that jumped 23% from last year, while Peloton shares dropped after the exercise equipment company’s fourth-quarter financial results missed Wall Street estimates. Peloton fell 8.5%.

The indexes are on track to end the month higher. The Dow is up 1.4% in August. The S&P 500 is 2.6% higher, and the Nasdaq Composite is up 3.1% this month.

Stocks are doing great, investors keep buying the dips, but some are warning this party is coming to an end.

In his weekly market wrap-up, Martin Roberge of Canaccord Genuity notes this:

Stocks have rebounded from last week’s decline and are flirting with all-time highs again. Undoubtedly, the speed and ease with which the major indices have recouped recent losses has fortified confidence in the buy-the-dip approach. Another confidence boost came earlier today at the Jackson Hole Symposium when Fed Chairman Powell reinforced the “transitory inflation” narrative (more below). The dovish nature of Powell’s comments helped several commodities to finish the week on a high note, especially gold which is now flirting with its 200-dma ~1,809/oz. Elsewhere, bond yields rose a tad higher and it looks like the downtrend from the May peak has broken, with a new uptrend forming. Sector-wise, the FDA’s full approval of Pfizer’s COVID vaccine along with emerging optimism that Delta-related COVID cases could be peaking lifted value/cyclical stocks. That said, growth stocks held their ground on the back of global economic data still pointing to a loss in momentum. 

We listened to Powell’s testimony earlier today and contrary to many Fed officials who this week hinted at a sooner-rather-than-later tapering announcement, the Fed Chair took a more balanced view, discussing at length why inflation would come down and prove temporary. While confirming that the labor market has made sufficient progress to start reducing the pace of asset purchases this year, Powell seemed reluctant to provide any timing given the spread of the Delta variant. That said, with many medical experts projecting an imminent peak in Delta infection cases, we expect this source of uncertainty should disappear by the time the next FOMC starts on September 21. As such, December could be when quantitative tapering begins. As a reminder, all four previous tapering episodes since 2009 led to market corrections. Time will tell if history repeats itself but as our Chart of the Week suggests, the growing divergence between US stocks and other risk indicators such as credit spreads, the CDN$, the yield curve and copper prices, suggests a rising correction risk going into the fall. We will offer more colour on our view when we publish our September strategy report next Wednesday.

In his latest weekly report, Francois Trahan of Trahan Macro Research writes:

Inflation remains on our minds albeit it has clearly faded as an investment theme in the eyes of consensus. We went from thinking the Fed was harmlessly wrong about their inflation forecast last March to now thinking there is a much bigger story at play here. In our eyes, inflation is likely to be a running theme in the markets for years to come, a backdrop few of us have experienced in our careers. This line of thinking leads us to believe that the Fed will eventually have to step in and tighten policy, making "long-duration" assets like Growth stocks a poor risk/reward, particularly at these valuations.

Please don't take anything in this report, or any of them for that matter, as a lecture. I do passionately believe, however, that every one of us needs to fill a gap in our education when it comes to inflation. We were all trained for a world where inflation is a non-issue, as it has been for almost 40 years now. That said, it increasingly feels to us like things could be "different this time" when it comes to the pricing dynamic in our economy. Maybe different from recent memory is a more appropriate way to express this? My reading list for vacation includes a few reads on the 1970s experience with stagflation. I did not think I would ever have to say "I am reading up on stagflation" but better to be safe than sorry. Ok, heading out with the RV to the Olympic peninsula for a few days. Enjoy your weekend folks.

He really does have an RV (seen pics) and enjoys driving it and going on excursions with his family.

As far as inflation, Francois thinks there's a lot actually that is "different this time":

 

No doubt, massive stimulus at this stage potentially adds fuel to the inflation fire but again, I need to see it spill over into higher real wages, and so far I am not seeing this (quite the opposite, real wages are declining as inflation proves stickier than initially thought).

Earlier today, I saw something Chen Zhao, Chief Global Strategist at Alpine Macro, posted on Linkedin:

This chart compares two different shocks to price levels in the U.S., one that occurred in the 2008 GFC and the other which took place during the 2020 pandemic crisis.

The first shock was permanently deflationary as it lowered the price trajectory, while the recent one appears to be transitorily inflationary. This implies that the core PCE inflation could fall to very low levels in mid-2022, if, as likely, the shock is transitory.


There's a lot riding on this transitory versus sticky or permanent inflation call. 

Yesterday, I spoke to HOOPP's former CEO, Jim Keohane, and he told me he thinks inflation is a big risk right now and that central banks need to raise rates as "we are in the mania phase".

Jim is worried that central banks have unleashed massive liquidity and are creating all sorts of bubbles.

And if they start raising rates because they fall behind the inflation curve, it will get ugly.

Of course, Keynes once noted "markets can stay irrational longer than you stay solvent" and most hedge funds will just continue frontrunning the Fed, staying Risk-On mode until the very end.

But as we enter the last stretch of the year, it will be interesting to see how market participants position their portfolios.

I just wanted to give you some food for thought after the latest Jackson Hole symposium.

Is the Fed prepping markets for some tapering?

Probably but until I see concrete actions, I remain skeptical that the Fed will actually taper, let alone raise rates.

Others also think the Fed is unlikely to taper anytime soon.

The problem is what happens if inflation sticks around and the market loses confidence in the Fed?

Well, that's when all hell will break loose, but don't worry, we aren't there yet (still, it's a good idea to hedge your bets here).

Below, Federal Reserve Chairman Jerome Powell speaks virtually at the annual Jackson Hole conference. Listen carefully to how he balances out competing views.

Also, Federal Reserve Bank of Philadelphia President Patrick Harker says inflation may last longer than currently expected and sees the Fed beginning to raise rates either late 2022 or, more likely, some time in 2023. He speaks on "Bloomberg The Open."

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