The Fed follows through with tapering … all eyes on the timing of a rate hike … when that might be coming

 

Well, things went as expected.

Today, the Fed officially announced the end to its $120 billion-per-month asset purchase program that it’s had in place since June 2020.

The tapering begins “this later month,” trimming purchases by $15 billion per month ($10 billion from Treasurys and $5 billion from mortgage-backed securities).

The program is scheduled to end by the summer. Of course, the committee left the door wide open to changes if conditions required it. From the FOMC statement:

The Committee judges that similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.

As I write Wednesday mid-afternoon, stocks are rallying on the news, bouncing off losses earlier in the morning. However, market action tends to be volatile on announcement days, so prices could have retreated by the time you read this.

***The bigger story for markets and your portfolio is the Fed’s take on inflation and rates

The Fed has repeatedly said our current struggles with inflation are transitory. Meanwhile, Fed Chairman Jay Powell has stressed that the end of the bond-buying program does not signal the beginning of a new rate hike cycle.

Neither narrative changed today.

Here’s the FOMC statement on inflation:

Inflation is elevated, largely reflecting factors that are expected to be transitory.

Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors.

And here’s CNBC on the timing of rate hikes:

The tie between interest rates and tapering is a vital one, and the statement stressed that investors should not view the reduction in purchases as a signal that rate hikes are imminent.

On the current schedule, the reduction in bond purchases will start later in November and conclude around July 2022.

Officials have said they don’t envision rate hikes beginning until tapering is finished, and projections released in September indicate one increase at most coming next year.

***Despite this, the probabilities suggest we’ll see more than one rate hike next year

The CME Group’s FedWatch Tool shows us probabilities for where rates will be in upcoming months.

As you can see below, if you look forward to June of 2020, there’s a 45% probability of a quarter-point rate hike. There’s a 14% probability of a half-point hike.

And if we go all the way to December of 2022, we see a 28% probability that rates will be targeted at 0.75% – 1.00%. implying more than one rate hike (it’s highly unlikely the Fed would raise rates more than a quarter-point at a time).

***Keep your eye on bond yields in the coming days

Over the last month, the market has been sending signals that it’s nervous about growth as well as monetary policy.

An easy way to see this anxiety is by looking at the “10-2 spread.” This refers to the “spread” in yields between the 10-year Treasury and the two-year Treasury.

In normal times, the longer you tie up your money in a bond (the 10-year Treasury), the higher the yield you would demand for it. The yield you’d want would certainly be higher than what you’d expect from a short-term bond (the two-year Treasury). After all, a two-year bond gives you far more flexibility compared to committing your money for 10 years.

Given this, in healthy market conditions, we usually see a “lower-left” to “upper-right” yield curve with a healthy sized 10-2 spread.

But when economic conditions become murky and investors aren’t sure what sort of economic and investment market conditions are on the way, this can change.

Specifically, uncertain economic times tend to flatten the yield curve. That’s because investors often sell short-term bonds (which pushes up yields) because they want to be ready for whatever happens in the economy (think “offense”).

Meanwhile, investors also buy 10-year Treasury bonds (pushing down yields) because they’re flocking to the relative safety of the U.S. 10-year to weather whatever storm might hit (think “defense”).

Below, we look at this 10-2 spread over the last year.

It widened through last spring based on hopes of a huge economic rebound. But since then, it’s been falling. And since October (circled) it’s dropped sharply.

As I write, its sits at 1.10%. That’s above its long-term average, so the value itself isn’t a red flag. But its direction since the spring, as well as the steep drop over the last month, reflect market anxiety.

If we see the spread widening in the coming days, it will signal increasing confidence from traders.

As I write, the 10-year Treasury yield is up slightly in the wake of the Fed’s statement. The two-year popped briefly, but is now drifting lower.

***Will higher rates mean the end of this bull market?

That’s the real question for investors.

Higher interest rates lower the present value of companies’ future earnings, dividends, and cash flows. All of this weighs on a company’s stock price.

Adding to the headwinds, higher rates mean that stocks face stiffer competition from higher bond yields.

Yes, that’s all bad at face value, but it’s not uniformly bad. As we’ve discussed here in the Digest, what drives a long-term stock price is the condition of a company’s earnings.

When they take a hit due to higher rates, then yes, it’s a negative for the stock. However, some businesses have the ability to pass certain costs through to consumers, therein maintaining margins and healthy earnings.

So, higher rates don’t spell doom for all stocks. They just point toward the need for greater selectivity in which stocks you’re picking.

***Legendary investor, Louis Navellier, has been saying this for weeks, predicting a narrower stock market as investors seek out inflation resistant companies

The best way to position yourself in a rising-rate environment is by focusing on companies rooted in fundamental earnings strength.

This is the basis for Louis’ entire market approach.

You see, Louis uses powerful computers to scan the market for the quantitative fingerprints of high-performing stocks. And these fingerprints usually all point toward one underlying trait…

Earnings strength.

Two weeks ago, Louis held a special event that explained how he identifies stocks with significant earnings strength.

In his Project Mastermind event, Louis detailed his quant-based market approach. It’s a system he’s refined over four decades of investing, based on one core takeaway: better investing comes through a computerized market analysis that focuses on fundamental strength.

To watch a free replay of the evening, click here.

Bottom line, with interest rate hikes now on the way, it’s time to be deliberate about positioning your portfolio for a new market environment.

Have a good evening,

Jeff Remsburg