Markets react to the U.S. Federal Reserve’s hawkish turn

The U.S. Federal Reserve made a hawkish pivot last week. Kristina Hooper examines the implications for markets, with a focus on tech stocks, and discusses what may come next.

As regular readers of my blog know, I have at times been something of an armchair epidemiologist over the past two years. What you may not know, but which my kids can attest to, is that I sometimes play the role of armchair sociologist, psychologist, and philosopher. For example, I am fascinated by my kids’ occasional tendency to “lose time” on important projects (which they were well aware of) and to suddenly “wake up” surprised when the deadline is imminent. It’s as if they are Rip Van Winkle and have just woken up after years of sleep, shocked at the progression of the world around them.

I couldn’t help but think of my kids (and my poor husband, who has been dispatched by them to the store for posterboard and/or magic markers late in the evening on more occasions than I want to remember) last week when the Federal Open Market Committee (FOMC) released the minutes of their December meeting. Reading those minutes, it seems as if FOMC members were suddenly surprised by labour conditions and the state of monetary policy, despite presumably having watched the situation closely as it evolved. For example, participants at the December meeting “remarked that the current economic outlook was much stronger, with higher inflation and a tighter labour market than at the beginning of the previous normalization episode.”

FOMC participants also seemed surprised by the size of the U.S. Federal Reserve’s (Fed) balance sheet observing that it “was much larger, both in dollar terms and relative to nominal gross domestic product (GDP), than it was at the end of the third large-scale asset purchase program in late 2014.”

As my kids would write via text (but never about themselves): smh (in other words, shaking my head).

There was one real surprise from the FOMC meeting

The real surprise in the meeting minutes was the Fed’s desire to begin shrinking its balance sheet this year. The Fed seems ready to begin this process soon after “rate hike liftoff.” This would be significantly earlier than the timing of balance sheet reduction during the last normalization period.

And so last week marked a significant hawkish pivot for the Fed. And I expect the Fed to find support for its stance in the December U.S. jobs report released last Friday. While non-farm payrolls created in December were low, that is less important than unemployment and wage growth. The unemployment rate fell to an impressive 3.9% while average hourly earnings rose 0.6% month over month, which was well above expectations.¹ Paltry non-farm payroll gains shouldn’t give the Fed any pause when it comes to tightening, but low unemployment and higher wage growth should make the Fed feel more confident about tightening this year.

Markets expect a more aggressive Fed this year

“Fedspeak” in the days before the release of the FOMC minutes, coupled with the actual release of the minutes, helped drive expectations that the Fed will be more aggressive this year; fed funds futures suggest a high likelihood of rate hike liftoff in March. The 10-year U.S. Treasury yield rose in response to this rather abrupt pivot by the Fed (as well as positive perceptions around the Omicron variant). As of this writing, the yield on the 10-year U.S. Treasury is now at levels that haven’t been seen since January 2020, before the pandemic began.

What are the implications for stocks?

This move in the 10-year U.S. Treasury yield has of course impacted the yield curve and has implications for fixed income. However, it has also had a very significant impact on stocks, especially tech stocks.

Conventional wisdom holds that stocks with high valuations are more vulnerable to a rise in rates on the long end of the yield curve. Long duration stocks — stocks that are expected to pay a large portion of their cash flows in the distant future — are also more vulnerable to a rise in rates on the long end as those future cash flows are discounted at a higher rate. Of course, many longer duration stocks are also higher valuation stocks.

And the poster child for longer duration and higher valuation stocks is the tech sector, which was at the epicenter of the sell-off last week. Anecdotally, I have found that investors have changed their sentiment on tech rather quickly; the sector is no longer perceived to be more of a “safe harbour” within equities but is now perceived to be very risky.

I would caution against an overreaction on technology. Yes, there is likely to be weakness in coming months as stocks in general, and tech in particular, adjust to a more hawkish Fed. However, I believe the growth potential for the sector remains strong. And one could make the argument that the tech sector may be well-positioned for a rising rate environment because it has less debt, on average, than other sectors.² If investors have a long enough time horizon, tech weakness could present an opportunity. I am reminded of the old adage, “Be fearful when others are greedy; be greedy when others are fearful.”

What to watch this week

Looking ahead, this will be a busy week for market watchers. Some key things I will be watching:

• European Central Bank (ECB) President Christine Lagarde speaks this week. For what it’s worth, I don’t think the ECB will pull a Rip Van Winkle and wake up surprised by our present reality – at least not yet. The European economy thus far has been more negatively impacted by the spread of the Omicron variant. Purchasing Managers’ Indexes (PMIs) for the Euro Area fell from 55.4 in November to 53.3 in December.³ PMIs were also down substantially for the UK from November to December. As Joe Hayes of IHS Markit explained, “The accelerated expansion in output we saw in November unfortunately turned out to be brief. Amid a resurgence of COVID-19 infections across the euro area, growth slowed to the weakest since March in December.”³ Inflation is running hot in the eurozone, just as it is in the U.S. The flash estimate for December inflation in the eurozone was 5.0%, up from November’s 4.9%; core inflation in December was 2.7%.⁴ However, I don’t believe the ECB is as interested in tightening as the Fed is. It expects core inflation to revert back to under 2% by the end of this year (although it acknowledges the risks are skewed towards higher inflation). That means the ECB will likely go slower on rate hikes than the Fed, and not shrink its balance sheet right away.
• Fed Chair Jay Powell will testify this week as well as part of his confirmation hearings. I don’t expect him to abandon his hawkish stance, although his words might soothe markets. He might even share that there is less pressure for the Fed to raise rates because it is focused on shrinking its balance sheet earlier in the normalization process. That might not change the time of liftoff (although I am still holding out some hope that the Fed doesn’t raise rates at its March meeting) but it does suggest the Fed may err on the side of fewer rate hikes in 2022.
• U.S. Consumer Price Index and Producer Price Index will be released this week (get your popcorn ready for this big event, given not just policymakers are focused on inflation, but so are politicians).

• UK GDP figures will be reported this week and will likely show pressures related to the spread of the Omicron variant.
• U.S. retail sales figures will be released later in the week and could also show some pressure caused by the spread of Omicron.
• Finally, I’m closely watching COVID infection rates in Asia, which are likely to rise quickly given the contagiousness of Omicron. I do believe this wave will be relatively short-lived, but it could be a very big wave, as it has been in other regions, which has negative implications for domestic economies, supply chains and global inflation.

Conclusion

Investors should brace for volatility in stocks, bonds, cryptos – in any asset class, really, as markets adjust to a Fed in normalization mode. We need to keep this in perspective, as we have lived through Fed normalization-induced volatility before and have survived.