Fed meeting to strike a difficult balancing act

At the start of this week US stocks have started to fall behind their European counterparts, there has been further gains for European stocks, after the Eurostoxx 600 reached a fresh record high at the end of last week. The mood across risky assets is mostly upbeat as we wait for the Federal Reserve meeting that will conclude on Wednesday. 10 -year US Treasury yields have stabilised around 1.5% after their sharp decline even after the 5% reading for US headline inflation for May, and the oil price reached a post-pandemic high. Expectations are high that the Federal Reserve will keep policy unchanged and continue to buy $120bn of assets each month. However, the market will be focussed on the tone that Fed chair Powell will strike, he needs to be dovish enough so that he doesn’t spook markets, but he needs to show the Fed’s willingness to be flexible and think about tapering, even if it is somewhere in the distant future. 

How to position for the Fed 

When global economies are strong, the focus is less on individual data points and more about central banks. The market seems to be on board with the Fed’s view on inflation – that the current spike in prices will be temporary. We know that some of the price pressures are temporary – such as those caused by bottlenecks and supply problems, however, some prices are likely to be stickier. For example, a microchip shortage earlier this year caused prices to spike, yet prices seems to have peaked, and we would expect microchip prices to fall in the coming months. However, other sectors such as hospitality sector are struggling to find staff, which means that wage increases are increasingly likely in the coming months. Thus, at Wednesday’s press conference the market will want to be proved right that the Fed is willing to stay strong and continue to look through price pressures. Any sign that the Fed is wavering and starting to get more concerned about rising prices, or any sign that the Fed may have to slam on the monetary policy breaks down the line, may see a rapid repricing of risky assets. 

Is the market complacent about inflation risks? 

It is wrong to think that financial markets are too relaxed about inflation risks, they’re not. In fact, it’s very stressful to continue to trade like inflation will be temporary when you see prices rising and read about growing wage pressures. Instead, the market is choosing to respect the Fed’s decision that US monetary policy won’t be changed for the long term and that price pressures will be temporary. For now, that is enough to distort market prices: stocks continue to rise, the dollar remains weak and US Treasury yields have taken a sharp drop (prices up) in recent weeks. We have seen in past crises that the Fed can distort asset prices through the mass purchase of bonds for a long time, which suggests to us that now is not a good time to fight the Fed. 

Why fiscal policy still matters 

Some interesting discussions are happening around the difficulties of assuming that asset prices will continue to go up even if the Fed remains in accommodative mode. Much of the growth that economies on both sides of the Atlantic are experiencing now is down to fiscal largesse from governments, for example cheques in the post from the US Treasury and the UK Chancellor’s furlough scheme. This has boosted consumers’ savings pots and the western consumer is in a very healthy position as we move through the summer months. However, with the US pretty much back to normal and the UK at stage 3 of its four-step programme for reopening after Covid, it is unlikely that more fiscal stimulus is waiting in the wings. This leads some analysts to be wary about the decline in fiscal stimulus and some are starting to wonder if inflation in the US has already peaked. Fear that the reflation trade could be behind us could see stock markets and other risky assets start to wither. We think that stocks could taper off first as commodity markets remain strong. However, Brent crude has doubled in price since November 2020, one has to wonder how long this reflation trade will last. The next phase for financial markets could be the pondering of declining fiscal stimulus, rather than the start of tapering by the world’s major central bank, and this could be the biggest shock for highly valued financial markets in the coming months. 

Trading opportunities once we get clarity on the Fed’s message 

From a trading perspective, we believe that asset prices will be fairly quiet as we lead up to the Fed meeting, the real move will happen after Wednesday. The high risk/ low probability event is that the Fed’s message is interpreted as being less dovish than expected and so risk sentiment falls away and equities drop, safe havens rise, Treasury yields rise, and the dollar starts to make a comeback. However, we think that the most likely outcome from this week’s Fed meeting is that it sticks to its dovish tone, while trying to make the market comfortable with the fact that tapering discussions are ongoing. The Fed’s “dot plot” of FOMC members’ interest rate expectations is also worth watching, to see if there are any individual members who have different views to chair Powell, and if the view that inflation will be temporary is widely held at the Fed. Fed chair Powell will need to be at his most dynamic on Wednesday. If he can convince the market that he is dovish and if the majority of the Fed seem to agree with his message then any weakness in risky assets leading up to this meeting could be a buying opportunity. 

Value vs. Growth  

A dovish Fed for the long term combined with reduced fiscal stimulus could have one lasting effect on financial markets, we may see the value/ growth tussle in equity markets dip more in favour of quality growth stocks and the tech sector and away from consumer stocks or value stocks like airlines, retail stocks and mining stocks that rely on fiscal stimulus. At the time of writing, the market is already showing signs of differentiating between value stocks. For example, the biggest loser on the FTSE 100 at the start of the week was IAG, the parent company of British Airways, which was hit by the news that the UK’s economy is not going to reopen fully on June 21st, and that rising case rates makes loosening the rules for leisure travel less likely. However, the best performing stock of the day was Royal Dutch Shell, which saw its price jump on the back of rising oil prices, the price of a barrel of Brent crude oil rose to more than $73 and was up 1.3% on Monday. Overall, we think that oil prices could remain strong as we lead up to the Fed meeting, and we would prefer energy companies instead of travel and tourism stocks both in the UK and the US where both countries have seen a sharp rise in coronavirus cases in recent days. 

High volatility assets and the Fed 

Elsewhere, is there a link between a dovish Fed, falling Treasury yields and rising meme stocks? Of course it’s too early to say, but AMC Entertainment is up more than 15% on Monday, although we would note that GameStop fell at the start of this week, suggesrtibng that these two meme stocks do not move in tandem. AMC is the latest darling in the retail trading world, but we have seen this story play out before, albeit with free popcorn this time, and it rarely ends well. Thus, even if 10% + moves in a day sound exciting, prepare for the worst when trading on the back of the momentum from the capricious retail army. Bitcoin is also higher today after Elon Musk said over the weekend that he would allow Tesla to accept Bitcoin if it becomes “greener”. Musk’s sentiments on Bitcoin are rarely consistent, but he is an influential voice in the crypto market, so watch out for what he has to say as it impacts the price action of cryptos.