Treasury yields, equity prices and the dollar appreciated in the intermeeting period of the Federal Reserve. As inflation remained subdued, the Fed decided to keep the fund rate around 1-1.25%. Inflation was below the 2% target throughout the year.
Balance sheet normalization started in October, with little impact on Treasury yields and mortgage based securities’ (MBS) spread, noted the Fed in minutes of its October meeting released on Wednesday.
Inflation remains persistently low. Increasing yields are expected to put more pressure on inflation. Total consumer price inflation was below 2% in September, and was lower than earlier in the year. Consumer prices rose by 1.5% while core consumer price index (CPI) grew around 1.25% during 12 months ending in September. Personal consumer expenditure (PCE) inflation, excluding food price and energy prices, was about 1.25% during the same period.
According to the Fed's minutes, “The staff’s forecasts for core inflation and, thus, for total inflation were revised down slightly for next year, reflecting the judgment that a bit of the unexplained weakness in core inflation this year may carry over into next year.”
The Fed also thinks that market participants read its policy change as less accommodative than expected. It makes sense as increasing rates and declining reserve balances mean a tightening stance. Treasury yields and the dollar rose modestly, which also validates the Fed’s observation.
Nonetheless, recent announcements regarding interest rate hikes and balance-sheet reduction had no impact on ecstatic equity markets.
Stocks continue to climb without regard to Fed’s policy stance
Stock markets continued to move up despite an anticipated interest rate hike and reversal of balance-sheet assets. The general increase in the equity markets can be attributed to the tax reduction reforms that are set to benefit U.S corporations. The Fed noted, “Broad equity price indexes rose notably, reportedly reflecting in part investors’ perceptions that tax reform was becoming more likely.”
The Fed also mentioned the following:Â “Asset valuation pressures across markets were judged to have increased slightly,”
What about transmission delay?
It should be noted that interest rates partially act through portfolio rebalancing, which delays the effect of rising interest on equity markets. If rates continue to rise, investors will have to rebalance their portfolios, affecting equity prices negatively.
The effect of balance-sheet reduction of the Fed is also delayed. The increase of bond supply in the market will reduce bond prices, increasing interest rates and reducing equity prices.
Note that gross issuance of corporate bonds dipped somewhat during the Fed’s intermeeting period. This also indicates that rising rates will hurt cheap financing for companies in the long run, affecting earnings and equity prices negatively.
It is also worth mentioning that reduction in the Fed’s balance sheet will decrease liquid reserves of commercial banks and, consequently, deposits of non-banking financial institutions, which can lead to withdrawal of risky investments from the portfolio.
All in all, once the policy is transmitted, equity prices will be affected. Rising interest rates and declining quantitative easing will impact equity prices negatively. The effect is not yet seen because of a lag in the announcement of policies and flow of funds. As reversal of policies permeates through the financial system, equity prices will certainly come under pressure.
Why isn't signaling working?
The lack of reaction from equity markets may be due to the Federal Reserve’s policy of clearly conveying current and future policy developments. This helped minimize the signaling effect of the news. Read the following excerpt from minutes of Fed’s meeting:
“A few participants mentioned the limited reaction in financial markets to the announcement and initial implementation of the Committee’s plan for gradually reducing the Federal Reserve’s securities holdings. It was noted that, consistent with that limited response, market participants had characterized the Committee’s communications regarding the balance sheet normalization program as clear and effective.”
Note that the Fed’s rate decision is based primarily on inflation measures. As inflation remains under pressure, the Fed won’t consistently increase interest rates. So equity prices won’t be affected much. On the balance sheet side, normalization will automatically affect yields, pressuring equity prices in the long run.
Takeaway
As equity prices aren’t yet affected by rising interest rates and balance sheet normalization of the Fed, it can easily be construed that interest rates and balance sheet reserves are irrelevant for stock markets.
This is not the case as the effect on stock markets is usually delayed due to the gap between policy announcement and implementation.
Investors should keep tracking interest rate decisions and balance sheet developments closely as that can materially impact prices of the post-QE markets.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
