Market Reacts to Powell’s Tapering Clarity

The FOMC, rather Fed Chair Jay Powell, delivered a little more certainty in Wednesday’s meeting and press conference in regards to tapering and that certainty helped provide a little more clarity on the rate hikes that might follow. Powell stated that a formal tapering announcement is all but assured at the November meeting, unless the September jobs report lays an egg (he didn’t say it in those exact words but you get the point).

He also added that he expected tapering to conclude by mid-2022 adding another dose of insight into the process that investors had been casting about for. Assuming tapering does conclude at mid-year, it’s not surprising then that half of the FOMC participants expect the first rate hike to now occur in 2022, probably around year-end. There’s a lot to ponder off this meeting so let’s take a more in-depth look in the sections below.


New Dots Not the Same as the Old Dots

The dot plots have become a headline feature for every quarter-end FOMC meeting and this one was no different. For the second quarter in a row, the FOMC moved forward rate hikes as they upped the inflation outlook to be hotter and stickier than what was forecast in June. The matrix below represents the latest dot plot of fed fund target rates estimated by each FOMC participant following the Wednesday meeting.

 

Source: Bloomberg

As shown, there are now half of the FOMC participants expecting at least one hike in 2022. Recall the June forecast was noteworthy for pulling two hikes into 2023 from 2024. Now the FOMC has essentially pulled one of those hikes into 2022 while still forecasting two more hikes in 2023 and another three in 2024 to reach 1.75% on a median basis. Rather than focus on the median level, however, look at the dispersion of estimates. For 2022, it’s fairly tight but as we move into 2023 the range widens which is to be expected given the host of uncertainties that still confront the economy as move through the various stages of the pandemic.  Expect continued volatility around the rate outlook until we more clearly emerge from the pandemic’s shadow.

Another important point from these projections is that many of the FOMC participants seem to not fully embrace the Fed’s updated policy framework that allows for a period of inflation running above the 2% target in order to achieve maximum employment. While the updated economic forecast raised the core PCE inflation rate for 2021 from  3.0% to 3.7%, acknowledging the higher and stickier inflation experienced so far, they have it declining rather quickly to 2.3% in 2022, 2.2% in 2023, and 2.1% in 2024. During that time they have penciled in six rate hikes, curiously aggressive rate hikes for a GDP they expect to decline from 5.9% this year to 2.0% by 2024 and inflation back to essentially target. The market sees that response and has priced accordingly. We discuss that market pricing action in the next section.

 


5yr – 30yr Treasury Yield Spread is Flattening off Fed Outlook

As we mentioned above, the Treasury market has taken the Fed’s more hawkish projections on rate hikes along with the growth and inflation outlook and has been busy flattening the yield curve, particularly the 5-year to 30-year area. The graph below illustrates this flattening via the difference in yield between the 5-year and 30-year Treasury.

 

Source: Bloomberg

Notice the first significant dip in the spread back in June highlighted by the red oval. That was the release of the June dot plots that surprised markets with two rate hikes brought forward into 2023 from 2024. That action was driven by the 5-year selling off with higher yields acknowledging the faster rate hiking outlook. Meanwhile, 30-year Treasuries rallied as investors surmised the Fed is not tightly wedded to the new policy framework that allows above trend inflation. They interpreted the updated forecast as a sign the Fed would act rather quickly in dousing any inflationary embers but that also limits potential growth as well.

Fast forward to Wednesday’s meeting and the pulling forward of a rate hike into 2022 following the conclusion of tapering.  You see a similar pattern with the 5-year Treasury selling off while the 30-year remains relatively unchanged and, thus, a further flattening in the spread is the result (blue oval).

Also, note the period prior to the pandemic and the spread. While we’re well off the highs of March there is still plenty of room to flatten further. But for investors needing to put money to work now, the five-year part of the curve is certainly more attractive than it has been for most of this year. Something to consider as that excess liquidity begs to be invested.


Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.15 0.47 0.75 1.09 1.83 2.29
0.50 0.13 0.44 0.69 0.98 1.69 2.18
1.00 0.13 0.41 0.66 0.94 1.60 2.05
2.00 0.40 0.60 0.86 1.48 NA
3.00 0.81 1.42 NA
4.00 1.37 NA
5.00 1.34 NA
10.00 NA

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Published: 09/23/21 Author: Thomas R. Fitzgerald