Why the stock market doesn't seem to mind that the Fed is scaling back stimulus

Published Wed, Nov 3 20215:31 PM EDTUpdated Wed, Nov 3 20218:08 PM EDT

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

The Federal Reserve managed to soothe markets with its view that the economy would improve and inflationary pressures would ease, even as it took the first major step away from the easing policy it put in place to fight the pandemic. Stocks rallied further into record territory Wednesday and bond yields were mixed. Longer duration Treasury yields like the 10-year and 30-year moved higher, but the 2-year, which most reflects Fed rate policy, was barely changed after the Fed announcement. Yields move opposite price. "Stocks seem to interpret this as dovish but rates were a little more mixed," said Mark Cabana, head of U.S. short rate strategy at Bank of America. "The back end of the curve sold off a little bit. They clearly understood [Fed Chairman Jerome] Powell's desire to remain patient if possible. But the front end of the curve is very focused on upside inflation risk." As widely expected, the Fed announced announced that it would begin trimming its bond purchases by $15 billion a month, starting this month. That would wind down the $120 billion a month bond buying program by the middle of next year. At the same time, the central bank continued to describe inflation as temporary, but elaborated on the fact that supply chains and bottlenecks were impacting prices. Some market pros had expected the Fed to drop the description of inflation as "transitory," so the fact it remained in the Fed statement was seen as dovish. Fed Chairman Jerome Powell elaborated on the Fed's characterization in his briefing, saying while some people viewed transitory as short-lived, the Fed meant it to mean that the inflation would not be permanent or persisitently higher. He also stressed the Fed would move to raise interest rates if inflation does not subside as it expects. The Dow, S & P 500, Nasdaq and Russell 2000 all rose to finish the day at new highs. The Russell was up the most, gaining 1.8%, compared to a 0.6% gain in the S & P 500. "The Russell 2000 is the clear winner and it is consistent with past periods where tapering has started. It is a sign of confidence," said Michael Arone, chief investment strategist at State Street Global Advisors U.S. SPDR business. "The Fed wouldn't be tapering if the Fed was expecting something to go awry with the economy. They are signaling they expect things to rebound. Small cap stocks are typically correlated with rises in interest rates." Markets have been focused on inflation, which has been hotter than expected, and traders have been betting the Fed would begin raising rates as early as next June. In the futures market, traders are expecting about five rate hikes by the end of 2023. Those expectations remained in place after the meeting, but the market moved slightly and traders now see a first full rate hike by next July . Prior to the Fed statement, the first full hike was priced in by late summer. "They do say in the statement that much of the economic outlook depends on the virus passing, vaccine progress and the easing of supply chain constraints and labor shortages. What I'm hearing from the chairman now in his press briefing is he expects all those things to get better, not worse," said Arone. While risk markets looked on the Fed's action favorably, inflation remains a wild card. "The Fed wants inflation to come down. They want to make sure the labor market recovery is very broad based," said Cabana. "Their base case is that inflation will subside. However risks are to the upside. Given the uncertainty from a risk management perspective, the Fed needs to be prepared to tighten policy if inflation does not subside."

Federal Reserve Chair Jerome Powell speaks during a Senate Banking Committee hearing on Capitol Hill, Washington, December 1, 2020.

Al Drago | Pool | Reuters