Chairman of the Federal Reserve Jerome Powell listens during a Senate Banking Committee hearing on “The Quarterly CARES Act Report to Congress” on Capitol Hill in Washington, U.S., December 1, 2020.
Susan Walsh | Reuters
The Federal Reserve could remain a source of angst for markets in the week ahead, with chairman Jerome Powell scheduled to testify twice before Congress and more than a dozen other Fed speeches expected.
The bond market’s reaction to the central bank this past week was unusually volatile.
Though the market was initially steady after the two-day Fed meeting and Powell’s briefing Wednesday, Thursday came with a big selloff in bonds and spiking rates. Traders reacted to the fact that the central bank is willing to let inflation and the economy run hot while the job market recovers.
In the approaching week, bond market professionals will be watching Powell and other member of the Fed for further cues.
“This is bonds’ — I wouldn’t call it day in the sun — it’s more like day in the tornado,” said Michael Schumacher, head of rate strategy at Wells Fargo. “Clearly the bond market is the one the equity market is watching right now, and normally that’s not the case.”
The Russell 2000, however, was hit the hardest, losing close to 3% for the week.
Yields ratcheted higher as the market sold off. Bond yields move inversely to price.
The benchmark 10-year Treasury yield, which impacts mortgages and other loans, rose as high as 1.75% Thursday, a move of more than 10 basis points in less than a day. It was at 1.72% Friday afternoon.
“The bond move has been huge, and it’s starting to scare people,” said Schumacher.
“There’s been this question hanging out there for awhile: How much of an increase in yield can some of the higher octane stocks take?” he asked. “There’s no magic number, but as we speak, the 10-year is up 80 basis points this year. It’s incredible.”
Powell testifies Tuesday and Wednesday before Congressional committees along with Treasury Secretary Janet Yellen on Covid relief efforts and the economy.
He also speaks on central bank innovation at a Bank for International Settlements event Monday morning.
Other central bank speakers this week include Fed Vice Chairman Richard Clarida, Vice Chairman Randal Quarles, Fed Governor Lael Brainard, and New York Fed President John Williams.
Inflation and the Fed
There is also some key data.
Important releases include the personal consumption and expenditure data on Friday, which includes the PCE deflator, the Fed’s preferred inflation measure. Core PCE inflation was running at an annual pace of 1.5% in January.
The Federal Reserve this past week took no action at its two-day meeting, but it did present new economic projections including a forecast of 6.5% for gross domestic product this year. The central bank’s forecast now shows PCE inflation going to 2.4% this year, but falling to 2% next year.
The majority of Fed officials did not see any interest rate hikes through 2023.
Powell reiterated that the Fed sees just a temporary pickup in inflation this year because of the base effects against last year’s numbers when prices fell.
The central bank will target an average range of inflation around 2%, so that number could exceed that threshold for some time. It’s a change to the Fed’s ground rules, which makes the bond market nervous.
Normally, the Fed would hike interest rates if inflation flared up to avoid an overheating economy and avert a bust cycle.
“For the bond market, and the Fed, there is a communications problem and there’s a consensus problem. There can’t not be tension,” said Diane Swonk, chief economist at Grant Thornton.
“They will be trying to clarify the Fed’s message, but without a consensus on what those numbers and guardrails mean, it will be hard,” she said. “They will be explaining themselves as economists, and they’ll be speaking a different language than the bond market speaks.”
Leo Grohowski, chief investment officer at BNY Mellon Wealth Management, expects the bond market could be more volatile than stocks, and inflation would be problematic for both.
At some point, he expects there could be a 10% stock market correction, and inflation or a sharp move in bond yields could be a trigger.
“The market is trying to make sense of what could be perceived as a disconnect, between their economic projections and the Fed’s dual mandate of unemployment and inflation,” said Grohowski.
“Yet, they’re committed to keep short rates on hold until the end of 2023,” he said. “That’s what the market is struggling with. I think it’s unsettling to me to hear words like ‘overshoot.'”
Rotation from tech into cyclicals
Grohowski expects what he calls the ‘great rotation’ from tech and growth stocks into cyclicals and value to continue. Growth and tech have been most sensitive to rising rates, and the Nasdaq has corrected more than 10%.
“I think we’re in the sixth or seventh inning of a nine-inning game. It’s not over, but I think we’ve seen the lion’s share of the great rotation out of growth, into value,” said Grohowski. He said that view depends on the 10-year not rising much above 1.75%.
Grohowski is concerned by the Fed’s willingness to let inflation overshoot because inflation is a negative for stocks.
Supply chain issues are a concern. He pointed to Nike’s comments Thursday that its sales were hurt by port congestion, and also the shortage of semiconductors, which is impacting automobile production.
“Inflation expectations are troublesome for P/E [price-earnings] ratios,” Grohowski said. The [stock] market is trading at 22 times our estimate for this year’s earnings.”
He said the market is having difficulty reconciling the lack of any forecasted interest rate hikes versus the strength of the Fed’s economic forecast.
“If you ask me what I lose sleep over? …It’s too much of a good thing. Too much of a good thing is being too accommodative,” Grohowski said.
Bond market direction
Schumacher said there’s a chance the bond market could steady in the next couple of weeks, even if yields tick up.
He said corporate pension funds appear likely to reallocate capital into bonds before the end of the quarter March 31, and that could be supportive. Also as the Japanese fiscal year is set to begin, there could also be new buying in U.S. Treasurys because on a currency adjusted basis U.S. debt looks very cheap, Schumacher said.
He is also watching Treasury auctions in the coming week.
The Treasury auctions $60 billion 2-year notes Tuesday; $61 billion 5-year notes Wednesday, and $62 billion 7-year notes Thursday.
In particular, Schumacher is watching the 7-year auction, which drew poor demand last month.
Week ahead calendar
Earnings: Tencent Music Entertainment
9:00 a.m. Fed Chairman Jerome Powell at Bank for International Settlement summit
10:00 a.m. Existing home sales
10:00 a.m. Quarterly Financial Report
1:00 p.m. San Francisco Fed President Mary Daly
1:30 p.m. Fed Vice Chairman Randal Quarles
7:15 p.m. Fed Governor Michelle Bowman
8:30 a.m. Current account
9:00 a.m. St. Louis Fed President James Bullard
10:00 a.m. New home sales
12:00 p.m. Fed Chairman Powell, Treasury Secretary Janet Yellen at House Financial Services Committee
1:00 p.m. Treasury auctions $60 billion 2-year notes
1:25 p.m. Fed Governor Lael Brainard
1:45 p.m. New York Fed President John Williams
3:45 p.m. Fed Governor Brainard
4:20 p.m. St. Louis Fed’s Bullard
8:30 a.m. Durable goods
9:45 a.m. Manufacturing PMI
9:45 a.m. Services PMI
10:00 a.m. Fed Chairman Powell, Treasury Secretary Yellen at Senate Banking Committee
1:00 p.m. Treasury auctions $61 billion 5-year notes
1:35 p.m. New York Fed’s Williams
3:00 p.m. San Francisco Fed’s Daly
7:00 p.m. Chicago Fed President Charles Evans
Earnings: Darden Restaurants
5:30 a.m. New York Fed’s Williams
8:30 a.m. Initial claims
8:30 a.m. Q4 GDP third reading
10:10 a.m. Fed Vice Chairman Richard Clarida
10:30 a.m. New York Fed’s Williams
1:00 p.m. Treasury auctions $62 billion 7-year notes
1:00 p.m. Chicago Fed’s Evans
7:00 p.m. San Francisco Fed’s Daly
8:30 a.m. Personal income/spending
8:30 a.m. Advance economic indicators
10:00 a.m. Consumer sentiment