It's
amazing how people can sometimes look at the exact same picture and see
entirely different things. That's art we suppose, or maybe it's an NFT. Anyway,
we digress.
It's also interesting how market participants can hear the same thing but have
an entirely different take on what was heard. That captures the essence of the
disparate reactions by the stock and Treasury markets to the latest FOMC
decision and press conference.
Granted both markets seemed happily aligned in the immediate wake of those happenings,
but subsequent behavior suggests things may not be so copacetic.
Change, No Change
What stood out for market participants were the summary projections for the
economy and the target range for the fed funds rate. One changed considerably
while the other didn't change at all.
The Summary of Economic Projections for 2021 showed an upward tilt to the median estimate
for the change in real GDP to 6.5% from 4.2%, a downward tilt in the median
estimate for the unemployment rate to 4.5% from 5.0%, and an upward tilt in the
median estimate for the PCE inflation rate to 2.4% from 1.8%.
What didn't change at all, however, was the median estimate for the target
range for the fed funds rate. That target range is expected to remain
0.00-0.25% through 2023.
In turn,
Fed Chair Powell didn't change his commentary at all, not when you really look
at it. He said (and we paraphrase):
Inflation
rates will be picking up noticeably in coming months given low base
effects, but any move above 2.0% is expected to be transient. I
would be concerned by disorderly conditions in markets or by a persistent
tightening of financial conditions that threaten the achievement of goals,
but the stance of monetary policy we have today is appropriate. We
think that our asset purchases, in their current form, are the right
approach. We could change them in a number of different dimensions should
we deem it appropriate, but for now we think our policy stance is
appropriate. It
is not yet time to start talking about tapering asset purchases.
In brief,
he said for the umpteenth time that the fed funds rate isn't going up anytime
soon and that the Fed is unlikely to be swayed by any scary-looking inflation
data that could present itself in coming months.
In brief,
what the stock market heard right after the FOMC decisions and press conference
was: "Party on!" In brief, what the Treasury market heard was:
"No need to worry about a taper."
On Second Thought
What the
Treasury market heard initially and what it subsequently thought have turned
out to be two different things. The subsequent thought was that "the Fed
risks playing with inflation fire and we might get burned."
Accordingly, the 10-yr note yield, which moved down to 1.63% (from 1.67%)
immediately after the FOMC decision and press conference, subsequently rocketed
to 1.75% on some inflation-fear boosters.
That move
is setting up to be an interesting test, not only for the Treasury market and
the stock market, but for the Fed as well.
The coming months are likely going to produce some scary-looking inflation data.
Fed Chair Powell suggested as much, citing base effects that play into
inflation calculations (i.e., prices this year will be comping against much
lower prices seen in the depth of the pandemic onset). In other words, the
inflation data is going to look quite inflationary, but the Fed's view is that the
scary stuff will only be temporary.
It will
be a very interesting test, because market participants know some bad inflation
data is coming, yet that doesn't mean market participants will necessarily greet
it with the Fed's insouciant take on matters.
The fact that the 10-yr note yield moved so quickly to 1.75% after the Fed
chair's latest remarks goes to show that it could end up being a trial by fire
for the Fed in the Treasury market in coming months.
A Special Dispensation
If the Fed isn't acquitted by the price action in the Treasury market, the
trials and inflation tribulations seem destined to spill over to the stock
market via the interest rate channel. They have already to a certain extent,
driving the underperformance of the growth stocks versus the value stocks.
The value stocks aren't
exempt from the valuation pressures created by rising interest rates, yet they
are being granted a special dispensation for now because the jump in long-term
rates is also a byproduct of expectations for stronger economic growth. That
stronger growth should lead to stronger earnings growth for these value plays,
most of which face much easier comparisons and have seen consensus
earnings per share estimates increase.
The latter has been an
important component of their relative strength thus far in the face of rising
long-term rates. Notably, despite a huge price increase for many value stocks
since last November, the price-to-earnings growth ratio ("PEG" ratio) of 2.0x for
the S&P 500 Value Index is the same as it was on November 1, 2020.
On a PEG basis, then, you're paying the same for expected earnings growth for the value stocks that you
were on November 1.
However, the yield on
the 10-yr note has gone up 90 basis points since November 1, putting a greater
onus on these value stocks -- and all stocks - to live up to the heightened earnings
expectations that have accompanied rising stock prices.
What It All Means
Fed Chair Powell sounds
comfortable with letting the economy and inflation run hot. He even sounds
comfortable leaving long-term rates alone. That could change, he implied, if
the behavior of long-term rates leads to disorderly activity in the markets or
creates a persistent tightening of financial conditions that get in the way of
the Fed meeting its goals.
For now, he is
steadfastly walking the party line with respect to the Fed's current monetary
policy stance. The stock market looks content to keep
partying on that line. The Treasury market, though, doesn't look so sure that
it's a good idea to stick to the party line.
Inflation data in the coming months is going to be a test of the resolve of both markets. If the
Treasury market fails to pass the open-book test that includes answers on
inflation already provided by Fed Chair Powell, then the Treasury market just
might spoil the stock market's party-like behavior.
--Patrick J. O'Hare, Briefing.com