If you ask one bank, the Fed will hike seven times in 2022. So, at every meeting starting next month.
That might sound daunting. It might also sound implausible.
To briefly recapitulate, the US economy is destined to show a sharp slowdown in Q1, even if the Omicron effect on spending was entirely front-loaded (i.e., confined to January). A 50bps rise in real yields was enough to push the S&P into correction territory last month (figure on the left, below), and although financial conditions remained very loose amid the selloff, signs of angst in credit are beginning to show up (figure on the right).
If the Fed doesn’t manage to shift the entire curve higher, rapid rate hikes risk a quick inversion. Although you could make the “false optic” argument by pointing to long odds of an actual recession, markets aren’t particularly forgiving when it comes to inversions in widely-followed sectors of the curve. The Fed would have to explain why they’re ignoring a purportedly “infallible” recession indicator.
Given all of that, some would argue it’s (very) difficult to imagine seven rate hikes over just 10 months. But, BofA’s Ethan Harris is going with it.
“Markets underpriced Fed hikes at the start of the last two hiking cycles and we think that will be the case again,” he said, late last month, when the bank officially changed their Fed call. Harris expects QT to begin in May. “When you are behind in a race you don’t take water breaks,” he said.
Harris addressed the elephant(s) in the room. “How will the economy and markets handle hikes?”, he wondered, on your behalf. “Should we worry about an inverted yield curve?”
The answers are, in order, “fine,” “it doesn’t matter” and “no.”
“The fundamental backdrop for growth remains solid regardless of whether stocks are flat or down 20%,” Harris said, after rolling out the old “the stock market is not the economy” cliché. That’s somewhat difficult to square with the (more colloquial) musings of Harris’s colleague Michael Hartnett who, in a recent note, cited the ratio of private sector financial assets to GDP in declaring a stock market crash the “quickest route to recession.”
Harris suggested the economy can absorb the hikes, even if stocks can’t. “Even the hikes we are forecasting only bring the real funds rate slightly above zero at the end of next year,” he remarked.
In a note out over the weekend, the bank’s Savita Subramanian took a closer look at what seven hikes might mean for the S&P. Consistent with Hartnett’s recent warnings about the perils of hiking rates into an overvalued market, she noted that the last time the Fed tried that, it “ended poorly.”
As such, Subramanian retained her year-end target of 4,600 (so, very little upside from current levels), but said that in BofA’s view, “risks to equities would be greater if the Fed did nothing.”
Why? Because, as she went on to explain, “runaway inflation would likely compress S&P 500 multiples and cut into earnings and if inflation moderates significantly, the Fed has signaled it will adapt its policy on a real-time basis.” Further — and this is likely to prompt some skepticism both from the cheap seats and the ringside VIP section — Subramanian said the fed funds rate has “no significant relationship to US equity returns.” I suppose the math is just the math (figures below).
So, if curbing inflation is critical to preserving lofty multiples and absolute stock returns don’t have a “consistent” relationship with the pace of rate hikes, what does matter to stocks?
Well, QT. Over the last dozen years, YoY changes in the Fed’s balance sheet explained more than half (51%) of the non-earnings YoY change in S&P 500 market cap. Pre-GFC, that figure was zero. Forward earnings explained 48% of S&P 500 returns from 1997 through 2009. Since then, earnings explained just 21% of monthly price returns, on BofA’s math.
So, balance sheet rundown matters. And it’s set to commence as soon as May. Jerome Powell’s track record when it comes to managing QT isn’t great, if you define success by the absence of stock market routs.
But perhaps more worrisome is the juxtaposition between multiples and the onset of a hiking cycle. As the table on the left (above) shows, hiking into a stretched market is risky business.
When it comes to dot-com comparisons, Facebook’s $250 billion one-day plunge and Netflix’s post-earnings selloff suggested the jury is still out on the contention that “this time is different” because today’s tech leaders will keep growing in perpetuity.
The Fed, looking to deliver a soft landing, wants to be deliberate and signal its moves well in advance, but it may not have that luxury. Seven hikes is a bold call but does speak to the apparent urgency of the situation. IMO, how the Fed manages QT will be the most important factor in whether it succeeds.
Is there a reason rate hikes have to come in increments of 1/4? The deepest, most liquid capital market in the world cannot possibly survive 2% interest rates, so why not ten basis point increases? Or five?
I still cannot understand the obsession the FOMC and everyone else has with their balance sheet. They would be far better off hiking rates as needed and leaving their balance sheet largely alone. Over a long period of time, if they left it alone the economy would grow into it. Besides, remember for the last 14 years the absolute crying about being at the zero bound? Better to lift off an extra 1/4 or two to be further off the zero bound. Why chance killing liquidity. The Volker rule got rid of the street being a liquidity buffer to financial markets. Extra liquidity from the Fed is in reality not extra. The hawks on the FOMC really do not understand this fact very well apparently. Also the GOP hates the Fed as it represents federal power.
I don’t know the answer to this question, but isn’t QT the only way the Fed can keep the yield curve from inverting?
I’m not sure if this directly addresses your question or the underlying topic, but a reverse “operation twist” (i.e. sell long term securities and buy short term securities on a $ for $ basis so no change to the total balance sheet size) should steepen the yield curve
I believe the reason they are targeting QT is to reverse existing inflation or to quote Powell, “to prevent sustained inflation”. Raising rates will increase borrowing costs and reduce liquidity but that will likely just halt inflation rise, not reverse it. In order to reverse inflation and keep it ‘transitory’ they need to sell debt. Honestly this is the FOMC trying to correct an overrun of stimulus or, their own mistake. But again, with no targets in place they are absolutely risking another overshoot. How do they know when they are supposed to be done? Without some metrics to guide these policies they are just overshooting all over the place.