The Fed and the Rule of Three
Author: David Stonehouse
July 27, 2021
The U.S. Federal Reserve (Fed) will conduct three important meetings over the next three months: monetary policy decisions on July 28 and September 22 sandwiched around the Jackson Hole Economic Policy Symposium taking place August 26-28. These events may well be the most consequential and closely scrutinized Fed activities of 2021 with important ramifications for interest rates, politics and, of course, the capital markets.
First, let’s recap the outcome of the last Federal Open Market Committee (FOMC) meeting on June 16. A surprisingly hawkish Fed raised estimates for U.S. GDP growth and inflation, while moving forward its consensus expectations for the timing of eventual rate hikes. U.S. bond yields initially spiked in response, a knee-jerk reaction reflecting the potential for higher interest rates, however, yields subsequently declined as the prospect of tighter monetary policy (including acknowledgement that the Fed had begun to discuss tapering bond purchases) apparently weighed on future growth and inflation expectations. Fed Chairman Jerome Powell took pains to reiterate the Fed’s commitment to maintain stimulus until full employment was reached, but skepticism seemingly remained. Increasing focus on the transient elements of inflation and the rapid spread of the delta COVID variant also likely pressured yields.
As a result, the bar looks to be high for the Fed to effectively communicate its intentions going forward. Given the strength of the rebound, it may be increasingly difficult to defend emergency measures such as the current pace of quantitative easing (QE). Yet, the Fed probably wants to avoid pre-emptively tightening as it has been accused of in the past, especially considering its new flexible average inflation targeting (FAIT) regime, which emphasizes full employment and a more tolerant approach to inflation. As a consequence, we anticipate a more dovish tone on Wednesday, with QE tapering delayed. The Fed is also likely to dissuade the market from anticipating rate hikes in 2022, hinting that a hike is unlikely until well into 2023. Such a message could cause long-dated bond yields to rise again, which the Fed would welcome as an indication it is moving closer to achieving its overarching goal of full employment.
Next up will be the Jackson Hole conference. While many observers speculate that QE tapering may be announced then, the Fed may be inclined to wait still longer. Several noteworthy pronouncements have come out of this symposium in the past, but more often the focus has been on the event’s main topic, which has yet to be announced, rather than on current monetary policy. Furthermore, this is not a formal FOMC meeting, and the Fed may well prefer to make policy changes during its regularly scheduled meetings.
That leaves us with the September meeting. Not only does pushing any tapering decisions out till then allow time for more dovish views to take hold, but it also aligns with the next publication of the Fed’s Summary of Economic Projections (commonly known as the dot plots). What’s important about this SEP is that it will be the first to incorporate forecasts for 2024, which would be an ideal time to conduct adjustments to policy.
Another factor in all of this is politics. U.S. President Joe Biden has an opportunity to remake the Board of Governors of the Fed in a new mould. With one of the seven slots open and the terms of the three highest ranking Fed governors (Randy Quarles, Richard Clarida and most importantly, Jay Powell) expiring in the next six months, Biden could appoint as many as four new officials with Senate approval. Powell is the odds-on favourite to retain the chairmanship, but is not a shoo-in, and will do nothing to diminish his chances of reappointment. Accordingly, in keeping with the “threes” theme, it seems more likely that Biden will end up nominating three new candidates. Either way, this represents yet another reason for the Fed to exercise patience and postpone any tapering announcement until at least September.
So, where does that leave markets? If the Fed does soften its stance, and succeeds in conveying that message, the yield curve is likely to steepen as short rates remain anchored and long rates rise. However, we do not expect a bond sell-off of the same magnitude as the first quarter, as growth and inflation expectations are unlikely to surprise as much. In this scenario, equity markets may pivot back to cyclical opportunities after favouring growth the past couple of months; indeed, sectors more exposed to a cyclical recovery rebounded dramatically last week after the sell-off ended on Monday. Still, there will be a lot to digest these next three months, and after such a strong rally, the market could be prone to a setback if the messaging around monetary policy is not interpreted favourably.
David Stonehouse is Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc. He is a regular contributor to AGF Perspectives.
To learn more about our fundamental capabilities, please click here.
To learn more about our fundamental capabilities, please click here.
To learn more about our fundamental capabilities, please click here.
About AGF Management Limited
Founded in 1957, AGF Management Limited (AGF) is an independent and globally diverse asset management firm. AGF brings a disciplined approach to delivering excellence in investment management through its fundamental, quantitative, alternative and high-net-worth businesses focused on providing an exceptional client experience. AGF’s suite of investment solutions extends globally to a wide range of clients, from financial advisors and individual investors to institutional investors including pension plans, corporate plans, sovereign wealth funds and endowments and foundations.
For further information, please visit AGF.com.
© 2023 AGF Management Limited. All rights reserved.
Written by
David Stonehouse, MBA, CFA®
SVP & Head of North American and Specialty Investments
AGF Investments Inc.
