The Federal Reserve surprised markets not with what it said but how it said it, and that may mean the path to tighter policy could be bumpy indeed for stocks. The Fed Wednesday delivered just the message investors expected in its statements - that it could raise interest rates soon and then begin to shrink its nearly $9 trillion balance sheet, which doubled since the pandemic. As Fed chairman Jerome Powell spoke to the media after the Fed's two-day meeting, a major stock market rally reversed and bond yields rose. Strategists were looking for some clarity on the Fed's plan to tighten policy, and a little more dovishness, or caution from Powell after days of stock market volatility. But Powell was firm in his position. He would not deny that the Fed could raise interest rates faster than expected, and that it could begin to shrink its balance sheet more quickly than in the past. JPMorgan chief U.S. economist Michael Feroli said Powell was the most hawkish he has ever sounded in his tenure as chairman. Powell repeated that the current tightening cycle is different than the last cycle with a strong labor market, strong economy and inflation running higher than target. "While remaining noncommittal, Powell clearly wanted to indicate that hiking at consecutive meetings was a possibility, a risk we've also been flagging," wrote Feroli. During the briefing, Powell made clear the Fed is set in its goal to fight inflation with higher interest rates. The chairman, who once termed inflation as transitory, said it could go higher and there are risks it could persist longer. "The Fed is now chasing inflation and is panicked," said Diane Swonk, chief economist at Grant Thornton. "His comments were more hawkish than the initial statement. It affirmed where the Fed is, and that is 'we still think variants are more inflationary than disinflationary,' and the Fed can't cure what ails us because it's the pandemic." While it is set to battle inflation, the Fed also expects to start decreasing its balance sheet more aggressively than it has previously. One way the Fed can decrease the balance sheet is by allowing maturing securities to roll off, without replacing them. Swonk said every $500 billion removed from the balance sheet is worth 25 basis points, or a quarter of a percentage point, of tightening. "Powell revealed the hawkishness that the statement obscured," said Swonk. Swonk said the markets should remain volatile, given the unknowns about the economy, inflation and the Fed. "Buckle up.. this is going to be a very volatile year...and you can't get away from that volatility. It's just one more element of uncertainty in an uncertain world," Swonk said. "We've just gotten another level of uncertainty in terms of what does the Fed think is more aggressive than last time." The S & P 500 ended Wednesday down 0.2%, at 4,349 and is now off 9.7% from its high. The 10-year Treasury yield rose to 1.87%, 11 basis points above the day's low. One basis point equals 0.01 of a percentage point. Fed funds futures also began to show that traders are beginning to bet on a fifth quarter point Fed rate hike for this year. They also now see a chance that the first one in March could be a half percentage point hike, double what's been expected. The market has been pricing in four quarter point interest rate hikes, while the Fed has forecast just three for this year. "He didn't push back against questions about whether they're going to go faster than just the 25 basis points a meeting," said Ben Jeffery, rate strategist at BMO. "He didn't really throw cold water on that idea. That was considered hawkish. The equity market was no fan of his briefing." Morgan Stanley Investment Management's Jim Caron said the lack of clarity on the balance sheet was at the heart of the market's reaction. Powell said the Fed does not have specific plans but would discuss the balance sheet in March and again at the next meeting and the one after that. That suggested to some market pros the Fed could start the wind down process in June, but it's unclear. "Despite signaling a rate hike at the next Fed meeting in March, the Fed statement initially calmed markets, but ultimately the lack of clarity on balance-sheet-policy emerged as a key source of uncertainty for both the Fed and not surprisingly, therefore, the markets," wrote Caron, chief fixed income strategist on the global fixed income team. "We expect policy uncertainty will be a theme that dominates asset prices at least until the next Fed meeting in March." Jimmy Chang, chief investment officer at Rockefeller Global Family Office, said the market has been worried that the Fed will tighten more aggressively through its balance sheet, and after the Fed meeting there was more uncertainty. "That is just open ended." he said. "This sets up an environment where everyone can have a theory on what the Fed will do. It just leaves people guessing. You have the whole gamut of expectations and quite frankly...a lot of it will be data dependent. It is a tricky environment. It is not just on inflation but on economic growth." Chang said the spread of the omicron variant of Covid could have weakened growth in the first quarter but it should rebound in the second quarter. However, the outlook for the second half of the year is uncertain. "The bigger picture is they are reversing the extremely accommodative policy stance that benefited the market in the last three years. This year is likely to be choppy because they are reversing the policy stance," said Chang.
Jerome Powell, chairman of the U.S. Federal Reserve, arrives for a Senate Banking Committee hearing in Washington, D.C., on Thursday, July 15, 2021.
Al Drago | Bloomberg | Getty Images
The Federal Reserve surprised markets not with what it said but how it said it, and that may mean the path to tighter policy could be bumpy indeed for stocks.