The Federal Reserve kept its aggressive monetary policy stance in place on Wednesday as it awaits “substantial further progress” toward its jobs and inflation targets. The S&P 500, which was slightly negative ahead of the 2 p.m. policy statement, gained ground and briefly touched a record high as Fed chief Jerome Powell spoke.
The Federal Reserve statement had a more optimistic tone, noting that “economic activity and employment have strengthened.” Even sectors most adversely affected by the pandemic “have shown improvement.”
Chair Powell balanced that positive talk with ongoing concerns that are likely to slow the Fed’s normalization of policy. Beyond ongoing concern about Covid, he noted a pandemic-driven shift to automation that could draw out an employment recovery for some service-sector workers. “It’s going to be a different economy,” he said.
The Fed statement also noted that “inflation has risen, largely reflecting transitory factors.”
Powell elaborated that inflationary pressures stemming from supply bottlenecks “are likely to be temporary as they are associated with the reopening process.”
The Fed chief once again conceded that some asset valuations are high: “Some of the asset prices are high. You are seeing things in the capital markets that are a bit frothy. That’s a fact.”
S&P 500, Treasury Yields React To Federal Reserve
The S&P 500, which rallied to a record high 4,197 in early stock market action before weakening, briefly eclipsed 4,200 as Powell spoke. In late-afternoon trading, the S&P was up 0.1%. Meanwhile, the Dow Jones slipped 0.3%. The Nasdaq composite was just above break-even.
The 10-year Treasury yield edged up 2 basis points to 1.64% ahead of the Federal Reserve statement, then eased back to 1.62% as Powell spoke.
Taper Talk Timing?
The Fed reiterated its commitment to continue asset purchases of at least $120 billion per month until the U.S. economy “substantial further progress.”
However, today’s Federal Reserve meeting was the last one before speculation heats up over when central bank asset purchases will begin drawing to a close. After March’s jobs report showed a surprisingly strong 916,000 gain, Powell said he wanted to see a “string of months” with equally strong reports before policymakers begin to even ponder a very gradual pullback of monetary accommodation.
On Wednesday, Powell only said that “a string of months” meant more than one. That keeps the door open for a taper discussion in June.
The eventual decision to taper will remove a key support for ultralow interest rates, as well as historically high stock valuations for the S&P 500 and broader market.
In coming months, rising Treasury yields will add to headwinds for the S&P 500 from President Joe Biden’s proposed corporate and capital gains tax hikes. Yet those pressures are still taking shape. Moderate Democrats will have to sign off on any tax hikes, and Fed chief Jerome Powell already has made clear that today’s meeting will be a nonevent.
Why Next Federal Reserve Meetings Will Matter
With jobless claims diving to pandemic lows, it appears that Fed chief Powell will have a string of three strong months by the June 15-16 meeting. That might be enough for the Federal Reserve to begin signaling a tapering of asset purchases by early 2022. Even if it isn’t, investors will position for an announcement that seems very likely to happen by July and almost certainly by September.
June’s meeting also will bring the next quarterly economic projections. That will show whether there’s any further erosion in Powell’s majority for keeping the benchmark Federal Reserve interest rate pegged near zero until 2024. In March, seven of 18 Fed policy committee members penciled in at least one rate hike in 2023. Four of those members saw a Fed rate hike in 2022.
By July, year-over-year inflation readings will move past last year’s three-month dive from March through May. Then Wall Street will begin to get a clearer view of whether the near-term inflation rise will only be transitory, as the Fed predicts. That outlook is key to the Fed’s current stance that the first rate hike of the cycle will wait until 2024.
The outlook for the Biden spending and tax increases should also clarify this summer. New outlays will be more front-loaded than tax hikes, and they will focus on those with highest propensity to spend. Both of those factors could add fuel to a hot economy in 2022.
Why Interest Rates Matter For S&P 500
As of Tuesday, financial market pricing indicated an expectation that inflation will average 2.39% over the coming decade. That’s the difference between Tuesday’s 1.62% 10-year Treasury yield and the -0.77% yield on 10-year Treasury Inflation-Protected Securities, or TIPS.
Moody’s Analytics Chief Economist Mark Zandi wrote this week that the negative inflation-adjusted Treasury yield likely “reflects the Fed’s trillions of dollars’ worth of Treasury bond purchases via its quantitative easing program.”
Worries about Fed tapering should stay on the backburner for now, but robust economic growth points to an eventual repricing. Zandi has predicted that the 10-year Treasury yield will rise to 2% this year, 2.5% in 2022 and 3% in 2023.
What might that mean for the S&P 500? Wall Street uses the 10-year Treasury yield as the risk-free rate to put a value on future corporate cash flows. As that rate rises, the future cash flows promised by fast-growing companies look somewhat less less enticing.
UBS equity strategist Keith Parker finds that each 50-basis-point rise in the 10-year Treasury yield compresses price-earnings multiples by six-tenths of a point. Based on the S&P 500’s current forward earnings multiple of about 22, that would equate to a nearly 3% decline in the S&P 500.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of financial markets and economic policy.
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