The FOMC meeting was important as many investors patiently waited to hear from Fed Chairman Powell and the committee about the long-awaited taper program. The Federal Reserve concluded the crucial meeting by leaving interest rates near zero.
As expected, the Fed announced the unwinding of the $120 billion monthly asset purchase at the end of the month or in December. Since Jun 2020, the Fed has committed to purchasing $120 billion in bonds - $80 billion in Treasuries and $40 billion in mortgage-backed securities each month to provide liquidity to the financial system. These bond purchases have added more than $4 trillion to the Fed’s balance sheet, which now stands at more than $8.5 trillion.
Powell stated the Fed intends to reduce by $10 billion and $5 billion, respectively, the current monthly purchase of $80 billion in Treasuries and $40 billion in mortgage-backed securities. By reducing $15 billion worth of asset purchases each month, the tapering program can end in eight months or during the summer of 2022.
The Fed Chairman continues to reiterate the word transitory to describe the current inflationary environment. He acknowledged the supply chain bottlenecks have led to higher prices in some parts of the economy. Inflation could also persist longer and at higher levels than expected.
Powell also mentioned that although the unemployment rate has dipped to 4.8%, the labor market is still weaker than expected, with fewer Americans employed today than before the pandemic. Inflation-adjusted wages also remain in the red.
Nonetheless, Powell assures the public the central bank’s policy will remain accommodative until they have reached their targetted goals on employment and inflation.
Since the timing of the tapering is known, market participants will turn their attention to the effect, if any, of the taper on future Fed interest rate hikes. How things will play out still depends on how successful Fed manages its exit from the money-printing stimulus program, the state of the economic recovery, and the inflation rate.
For investors, they will be operating in a new environment, where the Fed remains accomodating but not to the extent as before. While it may sound simple on the surface, it could get complicated and tricky, especially if inflation remains stubbornly high into next year. A mid-term election year can also lead to an increase in volatility in the financial markets.
While higher bond yields imply the economic recovery sustains, sharply rising interest rates can also lower the relative attractiveness of equities to bonds. On the other hand, a gradual rise in bond yields is ideal, as this implies the economy and market conditions are finally normalizing or returning to pre-pandemic levels.
Will the normalization create another Goldilocks environment, where the economy is not extreme or not varying drastically between the extremes, especially between too hot (hyper-inflation) and too cold (recession/stagflation)?
Enclosed are technical charts of the US equities market (S&P 500 Index - SPX) and key technical levels to monitor heading into the end of the year and 2022.