Why stocks rallied on the Fed, even with the more aggressive interest rate outlook

Published Wed, Dec 15 20214:42 PM EST

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

The Federal Reserve managed a dramatic switch in its policy outlook from ultra-easy to tightening without triggering a market tantrum - so far. Stocks turned positive after the Fed's 2 p.m. announcement that it would speed up the wind down of its bond buying program. The Fed also surprised investors with a forecast for three interest rate hikes next year, while markets had been pricing in between two and three. As Fed Chairman Jerome Powell briefed the media, the market continued to rise, and tech, which had been negative, began to surge. The S & P technology sector was up 2.8%, and tech drove the Nasdaq sharply higher, ending the day up 2.2%. "I think the band-aid is getting pulled off. The market's been waiting for this. It was selling off on the rumor and it's time to buy the event," said Tom Lee, founder of Fundstrat. Lee said the market is not disturbed by the Fed's rate forecast even though it was slightly more aggressive than expected. "Because there's still an out," he said. "The out is if omicron is bad…that's pretty bullish." Treasury yields, which move opposite price, initially moved higher. The 2-year, which most reflects Fed policy, jumped initially to 0.72% but slipped to 0.65%, slightly below where it was ahead of the announcement. The benchmark 10-year yield was up just about one basis point to 1.45%. "The known unknown becomes a known known and the market is strong enough to handle three rate hikes. We were already pricing in about three rate hikes anyway," said Jim Caron, head of global macro strategies on the global fixed income team at Morgan Stanley Investment Management. "Now I have seen how high rates are going and how fast it's going to happen. The uncertainty is removed from the market," Caron said. "From an equity perspective, now they just have to focus on earnings, margins and growth. It's kind of a sigh of relief to the equities market who thought it might be much more aggressive. It's kind of what we were thinking anyway." In early 2020, the Fed undertook a historic easing. It quickly cut its fed funds rate to zero and launched the bond buying, among other programs, as a way to fight the pandemic's impact on the economy and financial markets. At its last meeting in November, the central bank announced it would taper back the $120 billion a month bond buying program with a reduction of $15 billion a month. On Wednesday, the Fed said it was doubling the pace of tapering the purchases and would end the program in March instead of June. That now clears the way for the Fed to begin raising rates if it is ready soon after March, and the futures market began pricing in expectations for a hike at the April meeting. The Fed forecast included three more quarter point hikes in 2023. "I think the market in some sense has confidence in the fact they are going to do something for inflation, but it's not going to be a panicked tightening," said Jim Paulsen, chief investment strategist at Leuthold Group. "They are starting to address inflation...and for them unemployment is low enough, inflation is high enough. It's time for them to act." Paulsen said the market was also more confident because of Powell's briefing and his explanation of the Fed's view of inflation. "I thought he was incredibly forthcoming on a number of things. He didn't seem to dodge away from stuff. He just answered it straight up. I think that came across well," he said. Paulsen said the market's jump Wednesday was reversing its "little temper tantrum." The most speculative stocks and high fliers were washed out in the recent sell-off. On Wednesday, the Ark Innovation ETF , hard hit by the selling, jumped 2.2%. "I think most investors wanted assurance it wasn't going to be a brutal panicked catch-up reaction. It's still a very methodical approach," he said. "I think [Powell] did a good job of explaining two things - yes, we care about inflation and we're going to lean into it and we're not doing it in a panic reaction." Before the Fed's announcement, stocks were lower, but financial shares, utilities, health care, consumer staples and real estate investment trusts were all higher. Following the announcement, all major S & P sectors were higher with the exception of energy. Mark Cabana, head of U.S. short rate strategy at Bank of America, said the Fed's actions and outlook were hawkish. He said the Fed's inflation forecast changed dramatically. Fed officials now believe the central tendency for core inflation will be at a pace of 2.5% to 3% next year, up from its projections in September of 2% to 2.5%. "It's a material reassessment," he said. He noted the futures market shifted to give a 50/50 probability of a rate hike for March and 90% for May. "I'm a little surprised equities are hanging in as well as they are and actually increased on the back of it. I think they believe the Fed can regain control of of the inflation narrative," he said.

Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a live-streamed news conference following a Federal Open Market Committee (FOMC) meeting in New York, on Wednesday, Dec. 15, 2021.

Michael Nagle | Bloomberg | Getty Images

The Federal Reserve managed a dramatic switch in its policy outlook from ultra-easy to tightening without triggering a market tantrum - so far.