Guide to the November FOMC Meeting: What to expect and who will be the winners?
The next Federal Open Market Committee (FOMC) meeting will be held on the 2nd and 3rd of November. Aligned with the Federal Reserve's (Fed) promise to maintain the Federal Funds rate (interest rate) at near-zero levels until the economy returned to near full employment and inflation dropped to the desired 2% level, the discussion will revolve around growing tension between achieving full employment and stable prices. This promise serves the premise of the Quantitative Easing (QE) programme, with the Fed buying $80 billion of treasuries and $40 billion of mortgage-backed securities (MBS) every month since July 2020 to lower bond yields, increase liquidity, and boost the economic recovery coming out of the COVID-19 pandemic.
As the economic freeze started to thaw, unemployment fell back to 6% from 15% and inflation has ticked above the 2% benchmark since March 2021. Inflation currently sits at 5.4%, more than twice Fed's target. However, the economy has yet to reach full employment with five million fewer U.S. Jobs than before the pandemic. This is where the problem lies. Inflation has made substantial progress, passing the feds target, while the U.S. labour market has not made substantial progress and is still in the grey area.
A shift in the dot plot will be one discussion point in the upcoming meeting. The Fed dot plot refers to quarterly released plotted projections of fed fund rates and timing of rate changes made by the FOMC’s 18 members. Following the FOMC meeting on September 21st and 22nd 2021, the dots had shifted from the previous quarter’s projection of two interest rate hikes in 2023 to three/four rate hikes, starting as soon as 2022. Six to seven rate hikes through the end of 2024 were also projected. While these dots are not promises, they provide market directions of future lift rates and its timing, and therefore can be market moving.
Fed Dot Plot, showing FOMC members votes on rate rises, Source: Fed Summary of Economic Projections Sept 2021
The second and as important topic for discussion at the FOMC meeting is tapering (reduction of bond purchases). September’s meeting suggested tapering would begin this year, starting in either November or December, ending in mid-2022. Expected monthly reductions amount to $10 billion treasuries and $5 billion mortgage-backed securities (total of $15bn).
Seeing as supply chain disruption and elevated inflation would last longer than expected, the Fed may need to speed up the reduction of liquidity provisions and shorten the timeframe for interest rate hikes. While taking away the punch bowl is inevitable, gradual tapering procedures would invite further discussion to prevent elevation in volatility. Given uncertain factors such as additional COVID variants, weakness in the economic recovery, and S&P 500 correcting, changes in policy may arise in situations where economic recovery is not as smooth as planned. Otherwise, gradual tapering would be pursued.
The Wider Economy
Liquidity drives markets. During 2020 we saw an astronomical rise in equities as investors took on more and more risk due to the quantitative easing used by central banks around the world. Now that it seems tapering will commence in the upcoming FOMC meeting, there has been a huge shift in market sentiment of late. We have started to see the aggressive pricing of tapering and interest rate rises by the market, as yields rise and the major indexes become increasingly volatile. This reduction in liquidity will have major impacts on the economy and many asset classes.
The market has priced in a rate rise in 2022 (see below). Investors have recognised that inflation is not as transitory as it first seemed and are therefore expecting the Federal Reserve to raise interest rates sooner. The problem with the high inflation readings is that they have been due to supply-side constraints, for example, semiconductor shortages, lack of labour, and higher energy prices. Therefore, the actions of the Federal Reserve in the form of monetary policy and tapering of bond purchases will not resolve such issues. There is a risk that tapering may cause a slowdown in economic growth and have no effect on the higher inflation recently observed. We have already seen the US miss GDP Growth expectations, rising 2% against an expected 2.7%. Higher inflation and lacklustre growth could lead to stagflation, a nightmare for stock markets.
Probability of a rate rise in June 2022 is above 75%, meaning markets have priced this in, Source: investing.com
In addition to this, as mentioned, the expectation for tapering is a $15bn reduction in purchases by the Federal Reserve per month. If the number were to come in higher than this, we would see a significant drop in the S&P 500 and an even more substantial drop in the NASDAQ 100. This is because the NASDAQ 100 has a high weighting to richly valued technology stocks. Such high-growth companies prefer low inflation and interest rates. This is because it means a lower discount rate is applied to future cash flows, so investors pay a higher multiple today for a share of those future profits. In contrast to this, higher inflation and interest rates mean investors attach a higher discount rate to such cashflows and therefore ascribe greater risk to such companies. This causes a downward revision in valuation multiples and therefore price. High-growth companies also prefer ample liquidity because, as mentioned above, this encourages investors to take on additional risk. With this said, highly valued companies in industries such as renewables, cannabis, and AI may underperform as liquidity is drawn from the market.
Another asset class that will feel the pain of tapering and rising interest rates is the bond market. Bond yields move inversely to bond prices. As interest rates rise, yields rise to compensate. This causes bond prices to fall, meaning bond investors would nurse a significant capital loss. In addition, quantitative tightening by the Federal Reserve means they will reduce their purchases of bonds, meaning there will be less demand, causing prices to fall. Bonds are becoming an increasingly unattractive investment, especially in the face of rising interest rates, as stated by Warren Buffet in his 2020 letter to shareholders:
“Bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond had fallen 94% from the 15.8% yield available in September 1981?... Fixed-income investors worldwide – whether pension funds, insurance companies, or retirees – face a bleak future. “
With that said, there are sectors within the market that have the potential to benefit from higher inflation along with tapering and rising interest rates/yields. Value stocks (cyclical) typically perform better in this environment, as we have already witnessed with the monumental rise in many commodities and most recently oil.
Alongside commodities and miners, financials may also outperform. As rates rise the 10-year yield should appreciate at a faster pace than the 2-year yield, as longer duration bonds are more sensitive to interest rates. This means the spread between the 10 and 2-year Bond Yields (see below) should widen.
US Treasury 10-Year Yield minus 2-Year Yield, Source: FRED Website
This spread is a great indication of bank’s profitability, as banks borrow on the short end (2-year) and lend on the long end (10-year). As this spread continues to rise, banks' eagerness to lend also grows in tandem. This is one indication of the liquidity within an economy, and therefore if this spread begins to fall, we could see a recession in the near future. In addition to these industries, higher inflation may also benefit precious metals such as gold and silver. These assets have been proven to protect purchasing power over hundreds of years, so they could benefit if real rates (Interest rates minus inflation rate) remain negative.
Overall, it seems that tapering has been priced into the market, but any upside surprise in the tapering amount will cause a lot of market volatility. However, Jerome Powell will not surprise the market in such a way, as Federal Reserve communication has been very clear since the onset of the pandemic. As always, a diversified portfolio will protect investors no matter the outcome, however, a higher weighting toward value stocks and away from growth would probably be prudent.
I hope this article helped with your analysis of the FOMC event, and as always, please leave any feedback in the form at the bottom of the newsletter page!
Until next time,
Peter & Shannen (Lightstone Insights Analyst).
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.