The Federal Reserve has clearly broadcast a policy shift and should not create upheaval in markets next week if it decides to speed up the pace of its bond-buying taper and head toward interest rate hikes as expected. The Fed begins its two-day meeting Tuesday, Dec. 14. It could announce Wednesday that it will increase the pace of the wind down of its $120 billion monthly bond-purchase program. Indeed, Fed Chairman Jerome Powell told a Senate committee during testimony last week that the central bank would discuss speeding up the process when it meets. The Fed in November announced it was reducing its bond purchases by $15 billion a month, which would end the program by the middle of 2022. Strategists say that could now be accelerated so the program ends by March, and the Fed could begin to raise interest rates after that. The bond purchase program, or quantitative easing, was launched in early 2020 to counter the impact of the pandemic on financial markets and the economy. The central bank also had quickly cut the fed funds target rate back to zero. Market expectations for a rate hike "In terms of what investors are expecting from the Fed, I think the Fed has really re-messaged themselves in the Senate hearings and in a lot of ways market participants have begun to adjust their expectations around them, "said Patrick Palfrey, senior equity strategist at Credit Suisse. "Expectations for a rate hike haven't moved up meaningfully. They've moved up by a month." The futures market has now priced in odds of a full rate hike by May at 57%, according to the CME FedWatch Tool . Even before Powell's comments, Fed officials had been talking about accelerating the wind down. While Powell's words hit the stock market in a moment of turbulence last week, the fed funds futures and bond markets have been moving toward quicker interest rate hikes. At this point, three hikes are expected for 2022. The probability of three hikes by December 2022 was over 60% Wednesday, according to the FedWatch Tool. According to BMO strategists, fed funds futures for July 2022 reflect the first full rate hike, at 0.37%. "The Fed is probably going to accelerate the tapering. It's been advertised. They've opened the door to rate hikes in the first half of 2022, rather than the back half of 2022," said David Bianco, chief investment officer for the Americas at DWS Group. "So to me, the question is and the debate has moved to: How many times does the Fed hike? How high does the Fed have to go to quash inflation and bring it back to its target?" Bianco expects the central bank will start raising interest rates with a quarter-point hike next June. He expects two rate increases in 2022 and four in 2023. The Fed , in its own forecast, expects the first rate hike in 2023. There was no consensus on a rate increase for 2022, though half of the Fed officials projected at least one next year in their September forecasts. The central bank will release its new forecasts next Wednesday, Dec. 15. A key inflation report before the meeting Powell also said last week that the Fed perceives inflation as a risk and it was time to "retire" the description of rising prices as "transitory," or temporary. Another hot inflation report is expected before the Fed meets, with the consumer price index Friday expected to show a high pace of inflation close to 7% for November. The Fed has targeted core inflation at a range around 2%, and rate hikes are its most powerful tool to tame inflation. Credit Suisse strategists expect the stock market will continue to move higher into the first quarter despite the Fed. They also raised their forecast for the S & P 500 Wednesday to 5,200 from 5,000. "This constructive outlook is based on robust projections for economic growth in both real and nominal terms, further margin upside in cyclical groups, a pickup in buybacks and a favorable discount rate despite Fed tightening," they wrote in the note announcing the new target. Credit Suisse's Palfrey said the market will now focus on the strength of the economy, and inflation is actually helping corporate profits. "We don't see Fed rate hikes as a problem. When you look at market response around Fed rate hikes, traditionally the market does very well," said Palfrey. "The Fed renormalizing policy means you're moving to the middle innings of an economic recovery." He notes that over the past four rate hike cycles, the S & P 500 gained 9.5% in the 12 months ahead of the first hike. It gained 26% over the next three years. Palfrey said the threat to the market is when tightening policy inverts the yield curve, but that is not a near term risk. The yield curve has been getting flatter: a sign of future economic weakening. An inverted curve, meaning 2-year yields would rise above longer dated yields, like the 10-year, is a recession warning. But Morgan Stanley Investment Management's Jim Caron said so far the Fed has avoided a "taper tantrum," referring to the reaction to the Fed's move away from quantitative easing in 2013 . However, he said the bond market could react if Fed officials are more aggressive than expected with interest rate hikes in their new forecast. He expects two rate hikes to be penciled in for next year, but more would not be anticipated in the market. "The risks are pretty high that they announce a faster pace of tapering. I think that just gives them more optionality," said Caron, chief strategist on the global fixed income team at Morgan Stanley Investment Management. "I think what you want is the optionality to address inflation risks. The reality is you can't adjust interest rates until you're done tapering." Caron said the bond market has taken the tapering in stride. The 10-year as at 1.52% Wednesday, in the middle of its recent range, and the 2-year note yield was at 0.68%. The 2-year most reflects Fed rate policy. "If inflation doesn't come down in the second quarter of next year, if it doesn't come down enough then the Fed may feel it's appropriate to act and they want that freedom and mobility to do that," said Caron. "Looking at the 2-year right now, we're pricing in three rate hikes for next year. At this point, we're priced for that. I think it's pretty well expected. Most people will say tapering gets accelerated, whether its announced in December." Caron said the range of expectations around the behavior of bond yields next year is wide, and there is not really a clear consensus so the markets will also be watching economic data, particularly inflation. Bianco of DWS said for now, the market is trading a strong economy and the Fed should not upset it. "I think the market has prepared itself for this," he said. But Bianco added investors will have to be careful how they protect themselves against inflation and the Fed remaining hawkish. "To me, the year will hinge on whether inflation decelerates, and if it can decelerate without the Fed having to take aggressive actions," he said. Some economists expect inflation will peak at the end of this year and should slow in the new year.
Traders work on the floor of the New York Stock Exchange (NYSE) on December 02, 2021 in New York City.
Spencer Platt | Getty Images
The Federal Reserve has clearly broadcast a policy shift and should not create upheaval in markets next week if it decides to speed up the pace of its bond-buying taper and head toward interest rate hikes as expected.