How the financial markets may react to Powell's big speech Friday

Published Thu, Aug 26 20213:51 PM EDTUpdated Thu, Aug 26 20214:57 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Federal Reserve Chairman Jerome Powell is expected to say Friday morning that the central bank is closer to announcing it could step away from its super-easy stimulus policies, but markets could be rocked depending on how he says it. Powell is slated to speak at 10 a.m. ET as part of the Kansas City Fed's annual Jackson Hole Symposium. Stocks have been higher in the week ahead of Powell's comments, even as bond yields also rose on the belief that the Fed is moving closer to tapering its bond purchases. Yields move higher when bond prices fall. The 10-year Treasury yield was at 1.35% on Thursday, up from 1.25% at the beginning of the week. The Fed is buying $120 billion a month in Treasury and mortgage securities, and a steady stream of Fed officials have been talking up the idea that the central bank should soon start to pare their purchases. That is important to markets since at the end of the tapering process the Fed could begin to consider raising interest rates. "Powell's going to talk about tapering. There's no doubt about it," said Jim Caron, Morgan Stanley Investment Management head of global macro strategies. "Does he give us enough to think that at the September meeting it gets announced, or is it later on? I'm in the camp the Fed should wait a little bit." The big divide Caron said the market is divided on when the Fed will announce it will slow its purchases, which were initiated as part of an extraordinary easing effort undertaken to fight the pandemic. "I think market expectations are slightly leaning toward a later announcement, November or December," he said. Caron added the Fed could wait a few months because the risks of the Covid-19 delta variant are still unclear. The potential deceleration of global economic growth is also an issue, particularly with China possibly slowing its own economy with reforms on internet companies and other businesses. If Powell suggests the Fed could announce a plan after its Sept. 22 meeting to end bond buying, that could be seen as "hawkish" and trigger a market reaction. "If he specifies a time frame, I suspect it would be fairly soon. That's probably a pretty significant move up in yields and a pretty rough day in the equity market," Wells Fargo director of rates Michael Schumacher said. "If he just leaves it open in one of his usual comments, actually giving no timing, that's what most people expect. That's probably viewed as dovish." The benchmark 10-year is the most widely watched Treasury yield since it impacts mortgages and other lending rates. It also is linked to the stock market. In particular, growth and some tech stocks behave negatively if yields move up too quickly. InspereX trader David Petrosinelli expects Powell to indicate the tapering could be announced this year, but he expects no set timing from the chairman. "I think the market is expecting something firmer than no time guidance," he said. "I think the market would rally if he gives no guidance at all." Petrosinelli said bonds would rally, with rates dropping, because no timeframe would make Powell sound particularly more dovish than other members of the Fed who have said they could see tapering announced soon. If Powell provides no further guidance, Petrosinelli said it could indicate he sees the delta variant as a bigger threat than Fed officials have said so far. "It's really going to be the signaling and the messaging," said Caron. "If they do have words that we all believe is a signal for a September announcement for a tapering, I think what really matters a lot is then what Powell says around that. ...This is still a fluid situation." Caron said the Fed should not rush to taper, and he expects it to announce the end of the program later this year. "I understand the arguments. One is the Fed is doing $120 billion a month. I do think it is impacting negatively a lot of the liquidity in the Treasury market. They're doing $120 billion a month, and there's almost no new issuance for people to buy," he said. "You're getting artificially low levels of yields which clearly causes other asset classes to rise." Caron said if Powell does signal September for the announcement, the market could react in two ways. There could be an immediate jump in bond yields and a sell-off in stocks. But then yields might begin to fall, since some investors may look at a Fed taper as they did earlier in the summer when yields were falling. Yields moved lower then amid concerns that the Fed was moving too quickly, and that could hurt the economy and ultimately limit the central bank's ability to increase interest rates. If the chairman does not even mention timing, he would sound dovish and yields would initially fall and stocks would rise. "He's indicating a hot economy," Caron said. Bleakley Advisory Group chief investment officer Peter Boockvar said the market is focused solely on the Fed, and there is a good chance it moves markets Friday. He also said September may be too soon for the Fed to move though he believes it should be more concerned about inflation and move to announce the taper later this year. "I don't think he's going to stretch that far. There's a lot of information they're going to collect from tomorrow until the September meeting," Boockvar said. "Schools are going to reopen. People are going to come off of extended unemployment. We're going to see where the delta numbers go. He can afford to wait." Market mover Boockvar said no matter what Powell says, the market could move. Kansas City Fed President Esther George ; St. Louis Fed President James Bullard and Dallas Fed President Rob Kaplan spoke in favor of tapering sooner rather than later in the run-up to Powell's Jackson Hole speech. The bond program, or quantitative easing, is expected to take as much as 10 months to unwind. "I think if the theme of what he says tomorrow is along the lines of what we heard today absolutely" that will move the market, Boockvar said. "Every major correction over the past 11 years, outside of Covid and the correction in August 2015 when the Chinese revalued the yuan, every one was around QE, the tapering of QE or a rate hike." Caron said the bond market is trying to assess what Fed tapering means for interest rate hikes. At this point, Fed officials believe the terminal rate, or the final level of interest rates after they start hiking is 2.5%. But if the Fed moves prematurely, then that level could just reach 2% for instance because the economy may not be as strong. That would have implications for yields and, by his calculation, the 10-year should be about 1.3%. "If the Fed gets to a 2.50% Terminal policy rate and we assume 25bps rate hike per quarter, then the Fed ends their cycle at 2.50% by the end of 2025," Caron wrote in a note. "This suggests that UST 10y yield fair value should be 1.70% over the next quarter based on our estimations."

Federal Reserve Chairman Jerome Powell testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on "The Semiannual Monetary Policy Report to the Congress" on Capitol Hill in Washington, July 15, 2021.

Kevin Lamarque | Reuters