S&P 500 clinches fifth consecutive record close, equity bulls emboldened by dovish Fed

For reasons that are not abundantly clear, US equity markets were jubilant in wake of the latest Fed policy announcement, enjoying broad gains in wake of the Fed’s rate decision and monetary policy statement, and then extending on those gains as Fed Chair Jerome Powell spoke in the post-meeting press conference. In the end, the S&P 500 and Nasdaq 100 both managed to notch record closes for a fifth consecutive session, the former closing at 4560 (+0.6% on the day) and the latter surging above 16K for the first time to close near 16.15K (+1.0% on the day). The Dow also managed to get in on the spoils, closing above 36.15K (+0.3% on the day).

In recent days, the main driver of the march higher across US equity markets has been a strong Q3 earnings season, where more than 60% of companies have beaten analyst expectations and aggregative Q3 S&P 500 earnings growth is set to exceed 40% YoY on the quarter (well above expectations just a few weeks ago). Corporate American continues to thrive, in other words, despite 1) the ongoing presence of the Covid-19 virus, 2) severe global supply chain issues and bottlenecks and 3) rising labour costs.

But it was all about the Fed on Wednesday. To recap, the main news was that the Fed has formally kicked off the process of unwinding its extraordinary stimulus measures, first implemented in 2020 to support the pandemic stricken economy, and will reduce the monthly pace of bond buying by $15B in November and then again in December. Thereafter, the pace of further monthly bond-buying reductions can be adjusted as the Fed deems appropriate, though the bank said a continuation of the current $15B/month pace seems appropriate. This is bang in line with market expectations, with Fed members signaling well in advance that they had been thinking about taking this course of action.

The other major focus of the meeting was the tone the Fed (and Chairman Powell in the press conference) would adopt on inflation and the potential for rate hikes. Here, the Fed may have disappointed the hawks; in the statement, the current spike in inflation was still described as largely being driven by transitory factors (some hoped the “transitory” word would be dropped). In the post-meeting press conference, Powell said emphasised that it was the Fed’s base case that inflation would “abate” in Q2/Q3 2022 and, thus, the bank is prepared to be patient when it comes to rate hikes, thus allowing more time for the labour market recovery to advance. This emphasis on patience and the Fed’s belief that inflation is still transitory was interpreted as dovish and likely goes some way in explaining why stocks have rallied so much.

Door opened for hawkish shift in 2022?

While markets have largely interpreted the tone of the updated FOMC statement on monetary policy and Fed Chair Powell’s remarks in the press conference as dovish, some analysts have noted that the Fed did also appear to open the door to a hawkish shift in policy in 2022. Firstly, the Fed statement said the pace of the QE taper would become flexible from January, meaning that if they wanted to, the Fed could quicken the taper process if inflation risks remain elevated.

Moreover, though Powell was keen to impress that the Fed wants to be patient when it comes to rate hikes, he also emphasised that the uncertainty with regards to the path of inflation in the US economy is now more pronounced. Powell also noted that the Fed is positioning for a number of potential scenarios must implicitly mean that the Fed is preparing for a possible hawkish shift if inflation comes in hotter than expected over the coming months. While markets might have thus far interpreted events as dovish, it seems that Fed policy going forward is set to be data-dependent. If it looks as though the YoY rate of US CPI is set to remain elevated in the 4.0-5.0% region into Q2 next year, prepare for a hawkish Fed shift in Q1.