Can Stocks Handle Fed Tightening?

The stock market may still have to contend with the Russia/Ukraine situation, but the impending Fed rate hike may not be an obstacle for a renewed rally.  While the start of a series of Fed rate hikes is expected to begin at the March 15-16 FOMC Meeting, the consensus has moved to a modest 25 BP hike for the first move.  Fed Chair Powell's testimony on Wednesday and Thursday will not likely endorse this expectation specifically, but indicate that the pace of hikes will likely be faster than in the 2015-17 period.  Even if the frequency of rate hikes is faster than in this earlier episode, the stock market should take it in stride as long as economic growth does not look to be impaired significantly.   

The US economic data so far suggest GDP growth looks to be decent in Q122.  The rebound in January Retail Sales keeps open the door for consumer spending to grow at about the same pace as the 3.2% in Q421.   But, there are some negatives in the consumer outlook: /1/ The surge in oil prices represents a tax that will drain spending away from other goods and services and /2/ the end of the advance Child Tax Credits could hurt.  Aside from consumption, it remains to be seen how much of the massive inventory build in Q421 unwinds this quarter.  At this point, Unemployment Claims data suggest the labor market continues to improve.  Both Initial and Continuing Claims in February are below their Q421 averages.

The near-term inflation outlook is not good -- and unless it proves temporary could eventually force the Fed to tighten by larger increments.  The run-up in oil prices will filter through to higher transportation costs for many goods and services.  The dollar continues to fall relative to the Chinese currency, raising the risk of higher prices of goods imported from there.  And, there is no sign that wage inflation is abating.  Technically, bi-monthly sampling could keep start-of-year price hikes showing up in the February CPI.

This week's US economic data are expected to remain strong.   Consensus looks for an uptick in the Mfg ISM to 58.0 in February from 57.6 in January.  But, the evidence is mixed, so a dip can't be ruled out.  Consensus expects Nonfarm Payrolls to slow only modestly, to 450k m/m from 467k in January.  The evidence is mixed regarding a speedup or slowdown.  Consensus sees a downtick in the Unemployment Rate to 3.9% from 4.0%.  Whether it falls could depend on the Labor Force Participation Rat not rising.  Consensus expects a high Average Hourly Earnings, up 0.5% m/m after 0.7% in January.  It would remain above the prior 0.4% trend for the 3rd month in a row.

Russia/Ukraine and Fed Tightening Remain Market Problems

The stock market will continue to be vulnerable to developments in the Russia/Ukraine situation and concerns about the extent of Fed tightening.  President Biden believes Putin has decided to invade, possibly within days.  The FOMC Minutes point to more than 4 rate hikes this year as well as a large reduction in the size of the Fed's balance sheet.  But, comments by some Fed officials, including NY Fed President Williams, suggest the March hike will be only 25 BPs.

The FOMC Minutes were clear on two aspect of the extent of Fed tightening.  Rate hikes would be faster than in 2015-2017 period and that balance sheet reduction would be faster than in the 2017-19 period.  

Specifically, the Minutes said:

1.  Most participants suggested that a faster pace of increases in the target range for the federal funds rate than in the post-2015 period would likely be warranted, should the economy evolve generally in line with the Committee’s expectation. 

 

2.  Participants generally noted that current economic and financial conditions would likely warrant a faster pace of balance sheet runoff than during the period of balance sheet reduction from 2017 to 2019. 

3.  Participants observed that, in light of the current high level of the Federal Reserve’s securities holdings, a significant reduction in the size of the balance sheet would likely be appropriate.

 

The post-2015 trajectory of rate hikes was in 3 steps:  /1/ +25 BPs in 2016, /2/ +75 BPs in 2017 and /3/ +100 BPs in 2018.  (The upper limit of the Fed Funds Rate peaked at 2.5% at the end  of 2018 and stayed there until August 2019 when a series of 3 25-BP cuts began.)  Combining 2016 and 2017, the trajectory points to more than four 25-BP hikes in 2022 and possibly additional hikes in 2023.  These expectations should push up the "dots" chart that will be released at the March 15-16 FOMC meeting.  The prior "dot" chart showed an expectation of 3 rate hikes in 2022.

The monthly pace of Fed balance sheet reduction in 2017-18 was as high as $50 Bn.  Some Street economists are calling for as much as $100 Bn monthly reduction this time.

The stock market rallied strongly over 2017, as the Fed tightening occurred during a speedup in Real GDP Growth (to 2.7% (Q4/Q4) from 2.0% in 2016).  Stocks were range bound for the most part from the beginning of 2018 through the Spring of 2019.   Real GDP Growth slowed a bit in 2018 (to 2.3% (Q4/Q4) from 2.7% in 2017), although there was a more pronounced slowdown from H118 to H218 -- which stopped the Fed tightening.   

 

 

Will the Fed Pursue Aggressive Tightening?

The stock market will be focusing on the pace of Fed tightening ahead, as well as the Russian/Ukrainian situation.  The high January CPI raised the risk of aggressive Fed tightening, including the possibility of a 50 BP hike at the March meeting according to some Street economists.  At this point, however, a CNBC news report suggests the high CPI did not prompt a majority of FOMC members to change their expectation of a measured approach to tightening, that is in 25 BP increments.  They would be more concerned if inflation continues to be high in H222.  This week's release of the January FOMC Minutes could highlight this view.

In any case, there is still more evidence to see before the March 15-16 FOMC Meeting, which could influence market expectations if not Fed officials.  It includes the February Employment Report (March 4) and February CPI (March 10).  Strong prints will raise the risk of a 50 BP hike, while softer ones could hold down expectations of a rate hike to 25 BPs. 

Another high print for the February CPI cannot be ruled out.  The January CPI showed a broad swath of components with large m/m increases.  Higher wages and oil prices were likely the main culprits -- and their pass-through is unlikely to disappear soon.  Nevertheless, a couple of temporary factors may have exacerbated the January CPI's move up:  /1/ start-of-year hikes (which could persist to some extent in February because of bi-monthly sampling, but probably should show up to a smaller extent than in January) and /2/ a larger boost from the new seasonal factors (which will be balanced by smaller boosts in other months).  So, there could be some easing in February inflation.  Historically, the February Core CPI slowed in the two years ahead of the pandemic.  In addition, the January report contained evidence that price hikes stemming from supply disruptions may be peaking.  New Motor Vehicle Prices were flat and Used Car Prices slowed.

The large +467k m/m increase in January Nonfarm Payrolls also appear to have resulted in part from revised seasonals.  Seasonals added about 230k more to the m/m change than they did in January 2020.  There will be "payback" in the remaining months of 2022.  And, a smaller jobs gain in February can't be ruled out.

Regardless of the technical issue regarding seasonal adjustment, the economy still has to slow enough to generate labor market slack.  The sooner and larger this slack is created, the shorter will be the period of high inflation.   Given its dual mandate of maximum employment and low inflation, however, the Fed may be reluctant to aim for such a strong attack against inflation.  If it doesn't and the labor market remains tight and inflation high, the Treasury and stock markets will likely take on the job of braking the economy. 

This week's US economic data are not expected to give the Fed solace.  Consensus looks for the January PPI to speed up to +0.6% m/m from +0.2% for Total and to remain high at 0.5% for Core.  Consensus also sees January Retail Sales rebounding 1.6% m/m after -1.9% for Total and +0.7% after -2.3% for Ex Auto.  A large upward revision to December would seem to be a good possibility, as well. The Unemployment Claims data also will provide clues whether labor market slack is developing.  After giving mixed evidence in January (Initial higher, Continuing lower m/m), they suggest a modest tightening in labor market conditions has resumed.  The latest week's Initial and Continuing Claims are below their January averages (255k and 1.634 Mn, respectively).

Stock Rally to Continue This Week?

The stock market may continue to recover this week, as the risk is for a softer-than-consensus January CPI.   A softer CPI could temporarily counter the implications of the January Employment Report and take pressure off the Fed to tighten aggressively at this point.

The January Employment Report did not dispel concerns of potential aggressive Fed tightening.  Besides strong Payrolls, the uptick in the Unemployment Rate was not enough to be statistically significant.  Moreover, the increase in Labor Force Participation could have reflected the "small sample bias" of the Household Survey.  The sample may have just captured a lot of people who were in the labor market.  So, it is too soon to say the increase in the Rate is meaningful in terms of giving the economy more room to grow without inflation.  Indeed, the broader U-6 measure of labor market slack fell in the month.

Nevertheless, the Report did suggest a slowdown in economic growth at the start of Q122.  The clearest sign was the drop in the Nonfarm Workweek -- possibly impacted by the Omicron virus as many workers stayed home for part of the Survey Week.  It resulted in a decline in  Total Hours Worked, despite the surge in jobs.  The January level of THW is flat relative to the Q421 average, pointing to slower Q122 Real GDP Growth.  Although too early to be meaningful, the Atlanta Fed model's initial projection of Q122 Real GDP Growth is +0.1% (q/q, saar).

A slowdown in Q122 Real GDP Growth would be in line with Fed Chair Powell's expectation of a virus-related drag on economic activity at the start of the year.  He expects any slowdown to be followed by a resurgence of growth in Q222.  The high 0.7% m/m jump in Average Hourly Earnings, however, underscores why the Fed will have to act against a pickup in growth, possibly aggressively at some point, in order to create more labor market slack.  

High wage inflation does not mean that price inflation cannot be held down by temporary factors.  And, that may be the case with the January CPI.  In particular, covid-induced pullbacks in travel and eating out may have prompted airlines to cut airfares and restaurants to hold prices steady.  This could keep the January CPI below the consensus estimate of +0.5% m/m for both Total and Core.