Fed to market: inflation, what inflation?

The outcome of the Federal Reserve meeting on Wednesday was as expected – no change to rates or the pace of bond buying. However, this was still one of the most important Fed meetings in the past year. At today’s meeting, chairman Powell managed to straddle the central bank’s two biggest concerns when he said that the US economy remains in “recovery mode” from the pandemic and thus needs continued Fed support, while at the same time acknowledging the brightening outlook for US growth. The market reaction sent the Dow Jones to fresh record highs above 33,000, the Nasdaq managed to eke out a modest gain and 10-year Treasury yields were knocked back slightly from recent highs. 

A very decent growth upgrade 

In our view, the most important part of this meeting was the economic forecasts for the next three years and the Fed’s dot plot for future interest rates. The economic projections included an upgrade to growth, inflation and employment figures: GDP for 2021 was upgraded from 4.2% in December to 6.5% today (largely thanks to President Biden’s stimulus package). Inflation is expected to rise to 2.4% by the end of this year, before easing off to 2% and 2.1% in 2022 and 2023 respectively. The Fed also expects the unemployment rate to end the year at 4.5%, it is currently 6.2%. These revisions are large, which reflects the fast vaccine rollout and the end of lockdowns across the states, however, the Fed has materially upgraded its assessment of the US economy, and not merely pushed growth forward only for it to fall down the line. Is this a sign that the Fed expects President Biden’s stimulus package to have long term benefits to growth? Is it a reflection that the Biden presidency marks a return to public sector spending, and not just tax cuts, that will be a key contributor to the US economy over the next four years? It could also be a reflection of the expediated digitalisation of the global economy in the past year that will chiefly benefit the US. Either way, these forecasts are good news for those betting on America, hence the Dow Jones (the least techy part of the US stock market) rose to a fresh record during Fed chair Powell’s press conference. The market clearly thinks that Biden and extra government spending will boost Main Street more than Silicon Valley, although we would not write off tech stocks, who may lag the leaders in the current rally, but are unlikely to tank anytime soon; for example, Amazon, Apple and (dare I say it) Tesla, which was up a decent 3.7% on Wednesday. 

What’s next for interest rates 

The Fed’s dot plot is also worth looking at. While the Fed materially upgraded its assessment of the US economy, this has not translated into a faster pace of interest rates.  The dot plot shows that most of the 18 Fed officials expect no change in interest rates through to 2023, however, seven officials now expect rates to rise in 2022, up from 4 in December. The Fed also committed to buying $120bn per month of Treasury debt and mortgage-backed securities until the outlook “substantially changes”. The Fed remains concerned that higher inflation could be temporary, and that the US economy is not creating jobs fast enough to replace the 10 million jobs lost during the pandemic. Thus, while the market seems pretty happy with the pace of jobs growth, the 10-year treasury yield has jumped 20 basis points since the last NFP report, the Fed is less comfortable.

Boeing watch 

You may have noticed that we are looking closely at the price movements of Boeing, the airline maker. It has had some stunning daily price gains in the past few weeks and is leading the way in this recovery rally for Main Street. After dipping slightly earlier in the week, as volatility in global stock markets heated up on the back of rising bond yields, it had a decent 3.5% rally on Wednesday. We believe that the message from Fed chairman Powell – that the outlook is strong, but rates will remain low for at least another two years – is also good news for the Dow Jones, and consumer-sensitive sectors of the stock market. Technical indicators suggest that the outlook for the Dow Jones remains strong and we would agree with this sentiment. We also think that the Fed’s stance boosts the outlook for EM stock markets as it should keep the lid on the dollar for the medium term. The dollar index is close to its lowest level of the past month and it fell 0.5% on Wednesday. While stock markets remain glowing in the aftermath of Fed chair Powell, we expect dollar demand to remain weak, which is good news for GBP/USD, we expect this pair to attempt to break $1.40 yet again before the end of the week. 

What’s next for yields 

Treasury yields could be more nuanced. While we saw the 10-year yield fall (bond prices rise), on the back of the Fed meeting, we don’t think that the decline was meaningful. The substantial upgrade to the US economic outlook is likely to feed Treasury yields, and we could see 1.8% in the next 2 months. The rally may not be as fast in the coming weeks, but we still expect Treasury yields to rise, particularly 5-year yields and 10-year yields, although 2-year yields may be stickier. 

Overall, this meeting delivered more than was expected. A cheerful chairman = a decent end to the week for stocks, in our view. Chairman Powell may have just done his bit to tone down volatility as we move towards the end of the week.