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The Fed Makes A Mild Dovish Turn: Buy Stocks (NYSEARCA:SPY)

Fed Chair Jerome Powell And Janet Yellen Testify At Senate Hearing On COVID-19 And CARES Act

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The Fed’s Mild Dovish Turn

The Minutes of the Federal Open Market Committee from their May 3-4, 2022 FOMC meeting, released last week, point to a mild Fed dovish turn – from what it was an extremely hawkish policy stand.

Specifically, the Fed implied that they will quickly or “expeditiously” increase the Federal Funds rate to a neutral level over the summer, and then possibly pause in September to evaluate the effect of the monetary policy tightening on the economy. Here is the quote:

Many participants judged that expediting the removal of policy accommodation would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.

Minutes of the Federal Open Market Committee May 3-4, 2022

Furthermore, the Fed specifically indicates the return of the data-dependent policy, with what appears to be an equal treatment of inflation and unemployment. Here is the quote:

…Participants agreed that the economic outlook was highly uncertain and that policy decisions should be data dependent and focused on returning inflation to the Committee’s 2 percent goal while sustaining strong labor market conditions. At present, participants judged that it was important to move expeditiously to a more neutral monetary policy stance. They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.

Minutes of the Federal Open Market Committee May 3-4, 2022

Note, in the Minutes of the Federal Open Market Committee, March 15-16, 2022, the Fed mentioned being “nimble to incoming data”, but this appears to refer mostly to the inflation data, which raised the possibility of a more aggressive policy tightening. Here is the quote:

All participants judged that risk management would be important in deciding upon the appropriate stance of monetary policy, and that policy also would need to be nimble in responding to incoming data and the evolving outlook. In particular, all participants underscored the need to remain attentive to the risks of further upward pressure on inflation and longer-run inflation expectations.

Furthermore, the Fed specifically stated in March that the risk of higher inflation outweighed the risk of slower growth. Even more importantly, the Fed was concerned with de-anchoring of long-term inflationary expectations – which also supported a very hawkish policy stand.

Several participants judged that the upside risk to inflation associated with the war appeared more significant than the downside risk to growth.

In their discussion of risks to the outlook, participants agreed that uncertainty regarding the path of inflation was elevated and that risks to inflation were weighted to the upside. Participants cited several such risks, including ongoing supply bottlenecks and rising energy and commodity prices, both of which were exacerbated by the Russian invasion; recent COVID-related lockdowns in China that had the potential to further disrupt supply chains; and the possibility that longer-run inflation expectations might become unanchored.

Minutes of the Federal Open Market Committee, March 15-16, 2022

Thus, by comparing the Fed’s minutes from the March FOMC meeting and the May FOMC meeting, it appears that the Fed made a mild dovish turn. Note, the Fed is still hawkish, but not as hawkish as in March – thus the mild dovish turn assessment.

The Peak Inflation Expectations And The Fed’s Hawkishness

I noted on May 5th (right after the Fed’s meeting) that the market had reached the peak in inflation expectations and the peak in Fed’s hawkishness. Since, the inflation expectations have been falling, and currently, the expected inflation for the next 10 years is 2.66%, well below the peak of 3.02% (April 21st), and below the historically important 2.75% level. Here is the table:

Inflation expectations

Nominal Yield

Real Rate

BE Inflation Expectations

5Y

2.72%

0.27%

2.99% – sub 3%

10Y

2.74%

0.08%

2.66% – sub 2.75%

30Y

2.96%

0.60%

2.39% – sub 2.50%

Source: Global Academic View

Similarly, the expectations of monetary policy tightening peaked on March 4th when the Fed was expected to hike to 3.33% by July 2023, which is now reduced to 2.95%. Here is the table:

Monetary policy expectations

May 22

Jan 2023

Jan 2024

High point

First cut

Jan 27 -terminal

0.76%

2.64%

2.78%

2.95%

Jul 2023

2.70%

Dec 2024

2.95%

QE ended in March. QT starting in June – June-Aug $47.5 bill/month, after $95bill/month

Source: Global Academic View

Thus, the mild Fed’s dovish turn is justified – inflation expectations are re-anchored and within the normal historical range. No need for an extremely hawkish policy stand.

Implication For S&P 500 (NYSEARCA:SPY)

S&P500 (SPY) (SPX) (SP500) rallied after the March FOMC meeting because the Fed hiked by 25bpt and not by 50bpt as feared. However, the extreme hawkish policy surfaced with the Fed Chair Powell comments at the IMF on April 21st, after which SPY entered the vicious selling cycle culminating at the 20% correction level on May 20th.

It is important to understand the bearish case: historically, every recession has been preceded with the Fed’s interest rate hiking cycle, with only 2 recent soft landings (1984, 1995). Thus, the bearish case is simple: the unfolding Fed’s hiking cycle is likely to cause the next recession, especially given the implied hawkishness from the March FOMC meeting minutes.

However, the bullish case is also very simple: given the mild dovish turn from the May FOMC meeting, the Fed is just hiking to the neutral level from the very low base – the near 0% level. Most importantly, the currently expected terminal rate of 2.95% is still historically extremely low, and thus, unlikely to cause a recession.

S&P500 rose 6% last week in response to the mild dovish turn, and it’s likely the “bounce” will continue into the June FOMC meeting, and likely through the summer. Given the Fed’s mild dovish turn, and consequently a much lower recession probability, I am continuing to buy, and accordingly, I increase the rating from neutral to buy. Here is the SPY chart:

SPY price and moving averages
Data by YCharts

The Risk

Most notably, last week as SPY rose 6% amid the less hawkish monetary policy tightening expectations, the long-term inflation expectations increased, after falling for 4 weeks. Thus, the risk is that the market views the recent dovish turn as another Fed error – this will be evident in 10Y BE inflation expectations rising above the 2.75% level. In this case, the Fed will be forced to revert to a more hawkish narrative – which will likely cause the renewed selloff in stocks.

The second risk is related to the SPY structure and the firm-specific risk. The high-beta speculative technology sector (XLK) is 28% of S&P500 ETF, with another 20% coming from the combined tech-heavy communication sector (XLC) and consumer discretionary sector (XLV). That’s almost 50% from the sectors prone to volatility in an interest rate rising environment. Further, the large speculative stocks like Tesla (TSLA) could cause the spread in volatility from the firm-specific risk to the entire ETF, especially in an environment of low liquidity when the Fed hikes the interest rates.

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