Despite a mild selling in the broader market, the post-Fed meeting and press conference did little to dent the current equity outlook… for now. I expect that the stock market will continue its bullish pace over the remainder of the summer. I also expect that this will keep a lid on interest rates at this time, but the eventuality is that interest rates are going higher and the stock market will advance. But, the caution is the inflation news. If inflation continues at its current pace this will pressure the Federal Reserve. The Fed’s position is that inflation is transitory for now.
If you are looking to go long stocks there are a couple of things to look for at this point. First, the Federal Reserve will not be raising interest rates until about the end of 2023; that is 24 – 36 months from now. Second, the real thing that is driving the stock market is the Fed’s $120B monthly bond-buying programs. The Fed is buying $80B in corporate debt and an additional $40B in mortgage debt. This is keeping interest rates artificially low. This is what is driving the housing market to bubble-like levels. But, the Fed is thinking that the economy is transitioning and inflation concerns are not warranted at this point; albeit, inflation numbers were highlighted as noteworthy.
So, breaking down what is going on in the economy will allow you to keep an eye toward what is driving the stock market. First, a look at what stocks did post-meeting:
Post-meeting, the S&P 500 sold off abruptly, rebounded, and then after hours continued to sell back towards the lows. After all was said and done the S&P did not even drop below 1%; a nominal amount.
The 10-Year yield shot up as the Fed noted that inflation was transitory. The fact that the Fed acknowledged inflation was what the markets took note of. But, the process for the Fed is two-fold. First, they will stop purchasing corporate and mortgage debt. Then, they will raise interest rates. Therefore, there is still a great deal of time before investors need to start considering market moves at this point.
Federal Reserve Bond Buying
The Federal Reserve has been purchasing significant amounts of both corporate and mortgage debt. They are buying $80B and $40B, respectively, of both on a monthly basis. This has kept interest rates at ultra-low levels. This has certainly fueled the housing market craze that we have seen over the past few months as home prices are advancing at rates far above the pre-housing crises and bubble from 2008.
If you look backward in time, the average rate from what created the housing bubble in 2008 was approximately 6% for a 30-year interest mortgage. This level drove a housing bubble (along with other factors). then, when the bubble burst and the financial crises erupted, the Federal Reserve took extraordinary steps to coax the economy back into its full capabilities.
You can see the effects of the bond purchases throughout 2014 – 2018 as rates hit what was then ultra-low levels. But, then in 2020, the pandemic hit, and the Federal Reserve began again to take extraordinary steps to accelerate the economy. Mortgage rates were driven down to new all-time low levels. This is driving individuals into the housing market in droves. Price increases for housing are on average 1.5% monthly. Even during the housing bubble that turned into the crisis price increases were only 0.5% monthly.
Inflation is mostly transitory; or so says many. I believe it is both transitory and problematic while simultaneously the result of a perfect storm of events.
First, you have price pressures that are being driven by the reemergence of Americans from lockdown due to the pandemic. As Americans get vaccinated they feel rightly entitled to live again as they would desire; especially after not being able to do so for an entire year. This is driving price pressures upwards as demand for goods and services outpaces supplies.
Supplies are the secondary issue. Supply chains that were disrupted due to the pandemic and ensuing shutdown have not been re-established. As Americans demand more and more after reemerging, this is driving demand for products and services that simply are not available yet.
Keep in mind that this re-emergence of Americans is occurring during the summer driving season and vacation season. This is creating a perfect storm effect on price pressures.
The eventuality is that price pressures are going to abate as supplies start to catch up. As other countries push vaccination rates higher as they are this will help the process of getting supplies moving around the world once again.
All of this becomes a balancing act. Can supplies begin to arrive at distribution areas in order to alleviate supply constraints?
This is the challenge that is being faced by the Fed.
What to look for
Despite the future balancing act that the Fed is going to have to undertake there is one thing for certain that the Fed is likely going to do first and that is to reduce the bond-buying program. The mortgage-backed purchases are pushing the opportunity of individuals to purchase homes beyond what is normal. The Fed will very likely see this as an issue and taper off bond purchases at some point.
Also, the eventuality is that along with the $40B in mortgage-backed debt being purchased by the Federal Reserve, the other eventuality is that corporate debt purchases are going to be reduced. For now, the Fed is purchasing some $80B monthly. This will be a second step and something that is likely to occur soon.
Only after the Fed reduces its bond purchases will it then start focusing on the interest rate picture. They have just signaled that this will likely not occur until the end of 2023.
What to expect
Until the bond purchases dry up you can expect that the ultra-low levels on interest rates are going to drive the housing market as well as the stock market. Also keep in mind that with ultra-low interest rates the consumer will help to drive economic activity. As more and more Americans reemerge they will be demanding more and more from the service industry that was disrupted so significantly. More and more Americans will be obtaining jobs and this will serve to drive the economy more.
I expect heightened GDP growth going forward. This will help to propel the stock market. And, until the Federal Reserve actually does make moves to counter inflation and begin to normalize interest rates, I fully expect that the economy will be robust moving forward.
But, what about inflation? It is very possible that inflation is transitory right now. However, if the Fed falls behind the curve then price pressures may get to levels not seen since the 1980s. If that happens, the stock market could likely take a hit as the Fed starts to reverse itself and try to normalize inflation levels.
These are interesting times. If you are a speculator in the broader stock market you can expect continued stock prices heading higher. But, the eventuality is that interest rates will normalize and this may have an adverse effect on the indexes. They may sell-off. And, that sell-off has the potential of being sharp and significant. Let’s see how good the Fed is at balancing the economy.
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