03.22.21

Dovish Fed meeting fails to soothe markets

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2021 Outlook:
 
  • U.S. economy: Getting worse before it improves. 
  • Global economy: Ready to get back to normal—with the help of vaccines.
  • Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
  • Fixed income: A modest-risk overweight with a focus on credit sectors.
  • Equities: Lean toward small caps, emerging market shares and dividend payers.
  • Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
 

Quote of the week:

"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”– Sam Ewing
 

The Fed pulls off a delicate balancing act

Last week’s Federal Reserve meeting was an especially important one considering the unique set of circumstances facing the U.S. economy and financial markets. Since the Fed’s January gathering, we’ve seen the enactment of the Biden Administration’s $1.9 trillion stimulus package, increasingly positive news on the COVID-19 front and the rapid deployment of effective vaccines. These developments have fueled widespread optimism about resurgent U.S. growth, evidenced by rising interest rates in the bond market.
 
How best to sum up the meeting? The Fed was both bullish and dovish.
 
Let’s start with the Fed’s updated forecasts, which are quite upbeat, though not out of line with private forecasters:3
 
  • 6.5% GDP growth in 2021 (up from 4.2% in December) and solidly above-trend growth in 2022 and 2023
  • Core inflation, which strips out volatile food and energy costs, at or above 2% for the next three years.
  • 4.5% unemployment at the end of this year (down from 5% in December) and 3.5% unemployment by the end of 2023
 
Now for the dovish part: the Fed expects to keep its benchmark federal funds rate at its current range of 0%-0.25% through at least 2023. And at his post-meeting press conference, Chair Jerome Powell stated that the Fed has no plans to begin reducing its $120 billion/month quantitative easing bond-buying program.
 
So, compared to December, the Fed thinks the economy has strengthened enough to generate the highest GDP growth in decades, reduce the unemployment rate by an additional 0.5% and produce somewhat-above-target inflation. Normally, we’d expect such positive economic projections to be accompanied by tighter monetary policy to head off incipient inflation, but those steps aren’t in the cards for the next few years.  What’s behind this apparent disconnect?
The key to understanding the Fed’s bullish/dovish thinking is its recently adopted tolerance for the economy to run hotter to compensate for periods of low inflation (such as that seen during the pandemic). The Fed is now shooting for inflation to average 2% over the longer run. At his post-meeting press conference, Powell emphasized that for the Fed to tighten policy in any way, he and his colleagues must see actual progress toward its dual mandate of achieving full employment and stable prices — not just an expectation that such progress will materialize.
 
Consider that a little over a year ago, the U.S. unemployment rate was 3.5%, the labor force comprised roughly four million more people and inflation was still quite tame. So the Fed sees no need to sound the alarm on inflation risks now with unemployment at 6.2% and millions no longer even looking for work.4  Even sharply rising oil prices haven’t lifted the overall inflation rate from subdued levels.
 
The Fed’s new forecasts suggest that even economic growth of 6.5% is unlikely in the near term to produce the type of inflation that would require an earlier liftoff in rates. That doesn’t mean the Fed’s “crystal ball” will be right, of course, but it does tell us that the majority of Fed members remain (1) willing to accept inflation slightly above 2% and (2) under the impression that the U.S. is still in a deep economic hole and will be for some time.
 
Last Wednesday’s market reaction after the meeting was telling. Long-term Treasury yields barely budged, as investors “bought into” the Fed’s dovish outlook. For example, the bellwether 10-year yield rose just one basis point, from 1.62% to 1.63%, while the 30-year edged up to 2.42%.5 The S&P 500 Index moved higher after the meeting, led by interest rate-sensitive sectors like technology.
 
But on Thursday, doubts about the Fed’s willingness and ability to hold the line on near-zero rates against a backdrop of rising inflation expectations seemed to creep back in to investors’ psyches. The 10-year yield closed above 1.70% (1.71%) for first time since January 2020 before finishing the week at 1.74%.6 (Bond yields and prices move in opposite directions.) U.S. stocks (-1.47%) lost ground as well, showing that the equity market’s strength is driven, at least in part, by expectations that the Fed will keep rates low, as promised.6
 
Our full recap of the Fed’s March meeting is available here.
 

Weather or not?

Last week, with the Fed in focus, investors largely ignored a slew of U.S. economic data, all of which slowed markedly in February:
 
  • Headline retail sales fell 3% after rising 7.6% in January.7 (Figures of this magnitude sound more like annual than monthly changes, a testament to how volatile some data has been during the pandemic.)
  • Industrial production declined 2.2% due to sharp drops in manufacturing output and mining production.7 (In addition to manufacturing and mining, the industrial sector also encompasses utilities.)
  • Housing starts (-10%) and building permits (-11%) slumped after both recently hit their highest levels since 2006.7
 
To what do we attribute these downbeat results? Bad weather.
 
In particular, a winter storm that blanketed much of the country took a heavy toll on retail sales last month. And a deep freeze, especially in the South, accounted for the lion’s share of February’s drop in housing starts. Scarce resources like lumber became even scarcer. Mother Nature’s wrath also exacerbated disruptions in industrial supply chains. Most notably, petroleum refineries, petrochemical facilities and plastic resin plants were shut down for part of February. The inability of supply to match a rush of demand for products developed by these and other businesses could eventually contribute to short-term inflationary pressures.
 
But with spring’s arrival, weather disruptions should begin to melt away as a significant economic factor, replaced by (1) a sharply accelerating pace of vaccinations and (2) another massive influx of government financial assistance to individuals, states and localities. We expect both factors to fuel a burst of very good economic data in the coming months.
 
What’s more, consumers appear to be in a strong position to help the recovery:
 
  • Their willingness and ability to spend is on the rise, based on improving sentiment surveys and supported by a healthier labor market and reduced restrictions on businesses in many states.
  • Households, on average, ended 2020 in their best financial shape ever, bolstered by high savings rates (21% in January), dramatic gains in net worth (courtesy of surging equity and home prices) and increased disposable personal income.8
  • Incomes soared 10% in January thanks to the $600 checks delivered as part of the year-end stimulus package.9 As a result, we can reasonably infer incomes will shoot up by even more in March and April once the $1,400 checks from the American Rescue Plan Act (ARPA) hit Americans’ bank accounts, and will remain well-supported by the APRA’s more generous tax credits and unemployment assistance.
 
To be sure, the dash to provide COVID-19 financial relief and return economies to their pre-outbreak levels of output is fast becoming a U.S.-led story. The U.S. has supplied more fiscal aid to individuals than any other country (except for Japan) as a percentage of GDP, and it has fewer pandemic-related economic restrictions in effect than other developed economies, including the U.K. and eurozone.10  Against that backdrop, we still expect a broad-based recovery in the global economy this year, but it’s set to happen first and strongest here at home.
Sources:
  1. U.S. Treasury via Haver
  2. Marketwatch, Factset
  3. Federal Reserve
  4. BLS, BEA via Haver; Bloomberg
  5. U.S. Treasury
  6. Factset, U.S. Treasury via Haver
  7. Census Bureau via Haver, Federal Reserve
  8. Bloomberg, BEA via Haver
  9. BEA via Haver
  10. Washington Post (3/10/21)
 
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
 
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