Hawkish FOMC Minutes Spook Markets and Maul High Duration Equities, All Eyes On Powell Confirmation Testimony

FS Insight Team

Jay Powell has been a very dovish Fed chief and has taken great pains to prepare for investors for the Fed’s every move. This week though, the discussions of the FOMC at their December meeting spooked markets and raised the prospect of a more Old Testament style Fed that gets mailed 2x 4x’s in protest from construction workers claiming they no longer need their lumber since no one is buying houses. Markets became worried this week that an inner-Volcker may be stirring deep within Jay Powell and his FOMC.

The Federal Reserve minutes came out on Wednesday and resulted in a pretty significant market sell-off particularly in longer duration equities like Technology. The minutes showed that in addition to asset tapering and rate lift-off, the FOMC is now considering shrinking the size of its balance sheet. Markets did not like the more hawkish tone of the minutes and the prospects of a more aggressive Federal Reserve than many investors seemed prepared for. The committee also discussed raising rates as soon as March.

The Federal Reserve’s balance sheet has expanded to just under $9 trillion, the highest level in history. Previous efforts at shrinking the balance sheet didn’t even come close to getting it to pre-financial crisis levels, and it has obviously grown significantly since then. Fed officials have been becoming more concerned about inflation and have ditched the ephemeral ‘transitory’ term. The committee seems more concerned about the more broad-based inflationary pressure that might be caused from wages and housing/shelter.

Their inflation projections have gone up both for 2022, and notably 2023 as well. The Fed can shrink the balance sheet by letting securities ‘run-off’ when they expire, or by selling them outright which is more hawkish then letting them run off. Both options seem on the table as the Fed tries to get a handle on inflation. Wall Street currently seems to suspect they will let assets run off at a much higher rate then previous efforts last decade.

In the wake of the hawkish developments, markets seemed to suggest a higher probability for both a fourth rate hike in 2022 and the probability of a rate lift-off in March went up to about 2/3. One thing giving markets apprehension is likely the fact that the Fed has never simultaneously raised rates while also letting the balance sheet run off, or even selling securities in the open market. Powell had mentioned this after the FOMC meeting, but the minutes made it clear this was a prominent part of the discussion and several members supported shrinking the balance sheet very soon after lift-off. Even traditional doves are joining the chorus.

Another factor that is complicating matters for the world’s most powerful Central Bank is that it has tied itself in somewhat of a knot around data. Continued progress in the labor market is giving it less and less room to maneuver since the primary figure it is watching to guide monetary policy is now the labor market.

The Fed Minutes contained a phrase that investors really hate to see from an FOMC that has been so incessant on preparing markets for its action. The minutes stated that rising inflation levels and a tight labor market could result in lifting off rates “sooner or at a faster pace than participants had earlier anticipated.” In other words, the Fed may be forced to take policy action that would likely cause a vicious price reaction from markets.

Jay Powell’s confirmation hearing is next week in the Senate. He was last confirmed in the Senate in 2018 with 84 votes and 68 of those Senators are still serving in the body. Elizabeth Warren should have some extra ammunition against Powell as revised disclosures from recently departed Vice Chair for Supervision Richard Clarida seem to undermine the explanation that he initially provided. Expect grand standing, but Powell’s confirmation is all but assured.

The tapering of monthly purchases of $80 bn of Treasuries and $40 bn of MBS began in November, and was accelerated in December.. The Fed is currently purchasing $60 billion of securities a month, half of the original level of purchases. The Fed will be done with asset purchases in mid-March 2022 at this pace.  The benchmark yield on the 10-year skyrocketed 25 bpts in less than a week to  1.76%.

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