The Federal Reserve looks set to begin removing easy policy this year, but the market took the message in stride and stocks rallied. In the bond market, however, traders said the rise in Treasury yields, which move opposite price, was beginning to reflect the idea the central bank could move to raise interest rates. Higher interest rates could ultimately be a negative for stocks and trigger selling in the bond market. Capping the Fed's two-day meeting, the central bank signaled in its statement and projections on Wednesday that it is moving toward announcing a paring back of its bond purchases this year. The Fed said if progress continues as expected, a "moderation in the pace of asset purchases may soon be warranted." The Fed's forecasts also showed that members see higher inflation, and that half of the 18 Fed officials could consider an interest rate hike next year. 'A bit hawkish' In June, a wide majority of Fed officials expected no rate hike for 2022 and saw two rate increases in 2023. In its latest forecast, it still does not include a full rate increase, but nine members said they expect one or more interest rate hikes next year. Currently, the central bank is keeping its fed funds target rate in a range of zero to 0.25%. "It was in the end, a bit hawkish," said NatWest Markets' John Briggs. "Powell's tone said he was ready to go, and he said basically the fact they want to end tapering by mid-2022 is more important than when they start because that tells you when they start the clock on rate hikes." Stocks, which were higher all day, continued their rally Wednesday afternoon after the Fed announcements and a briefing by Fed Chairman Jerome Powell. The Dow closed off its highs but was still up 338.48 points or 1%. Futures were higher again on Thursday. Peter Boockvar, chief investment officer at Bleakley Advisory Group, said the stock market was not reflecting the day's news. "The market is not even paying attention to it," he said of the new rate hike forecast. "We have to get through the tapering first. ... We got another five or six weeks until we have to think about it. I think if history is any guide on rate hikes, skating through it is not going to happen in an easy way." Since the financial crisis, Boockvar said every move the Fed has made to tighten triggered a negative stock market reaction. "They just got a six-week hall pass," he said, adding that the market often reacts to Fed adjustments beyond the first day. A 'flattening trade' for bonds Following the Fed's announcement, the 2-year Treasury note edged up to about 0.23%. The 2-year is most influenced by the central bank's interest rate moves. "With Powell saying the committee says tapering could end in the middle of next year , that opens up the idea of a rate hike at the end of next year," said Briggs. "It's a flattening trade, which is a classic rate hike cycle trade. It's not massive, but it's definitely entrenched in the market." That trade was reflected by a larger move higher in the short end of the Treasury yield curve, or the 2-year note, compared with the 10-year note yield, which moved just slightly higher. The trade is termed "flattening," since the move brings both yields closer together. The curve flattens on interest rate hikes, since it is perceived that economic growth will not be as high in a rate hiking cycle. The Fed did not detail a time frame for starting the taper, giving itself room in the event the battle in Congress over the debt ceiling becomes negative or the pandemic worsens. But market pros say it looks like November's meeting will be when the Fed announces that it is set to pare back its $120 billion in monthly bond purchases, and that it could start in December. "Starting tapering is like jumping off the high diving board. The time to ponder whether there's enough water in the pool is not on the way down and they basically said let's put it off a meeting," said Vince Reinhart, chief economist at Mellon. "I think everyone will shift their expectation to the announcement at the next meeting to start the month that follows. It meets the previous guidance that they'll start tapering by the end of 2021." Reinhart said focus will now be on the September employment report, but Powell said he expects that enough progress has been made on the labor front. "My own view is the test for substantial further progress on employment is all but met," Powell said. Diane Swonk, chief economist at Grant Thornton, said it's clear the Fed is more concerned about inflation even though it still terms it as "transitory." That is evident in the move by more members to expect a rate hike next year. The employment report is important but it may not matter if it is weaker than expected again. In August, just 235,000 jobs were added. "Powell said if the next one is softer, it's not going to stop them from tapering. This is more hawkish on rates in the next two years. It's not insignificant," Swonk said. The Fed now forecasts core inflation to rise to 3.7% this year, compared with a 3% forecast in June. For next year, officials see inflation at 2.3%, up from 2.1% in their last forecast. Headline inflation, including food and fuel, is expected to rise to 4.2% this year, up from a forecast of 3.4% in June. The Fed's new rate interest rate forecasts reflect higher inflation. "That is much more rapid than what we had coming out of the financial crisis. Their concerns about inflation are clearly rising," Swonk added. She, too, said the stock market appeared to ignore the headlines. "I think they're complacent. This is a consistently complacent financial market. They have faith in the Fed," she said, adding that if inflation is too hot, the Fed is going to have to fight it with interest rate hikes, a negative for markets.
Federal Reserve Jerome Powell testifies during a Senate Banking Committee hearing on "The Quarterly CARES Act Report to Congress" on Capitol Hill in Washington, U.S., December 1, 2020.
Susan Walsh | Reuters
The Federal Reserve looks set to begin removing easy policy this year, but the market took the message in stride and stocks rallied.