Wall Street is counting on a key pivot from the Fed that could rattle stocks
- Market expectations of higher inflation have ratcheted up following the passage of the Republican tax cut legislation.
- The Federal Reserve is likely to acknowledge this pick-up in its post-meeting policy statement, although no move on rates is expected.
- Any hints of renewed Fed concern about inflation could further upset the bond market, which in turn might be bearish for stocks.
- "We believe rates across the curve are headed higher," write Bank of America-Merill Lynch strategists in a research note.
The Federal Reserve is all but set to keep interest rates on hold at this week's policy meeting, forcing traders to turn their attention to the central bank's statement for any changes in the language that signal something about the likely pace of interest rate hikes this year.
The Fed's own forecasts point to three rate increases in 2018, but financial markets are starting to worry the central bank might be inclined to tighten monetary policy more quickly if, as some expect, the recent tax cut legislation gives growth a temporary boost, pushing up inflation with it.
Keep in mind, the Fed has been falling short of its inflation goal for most of the economic recovery, so reaching the inflation target quicker would be a good thing from the perspective of workers and the economy.
However, for investors trying to gauge the investment environment a few months hence, initial excitement over the tax cuts, which has propelled stocks to repeated record highs, can quickly devolve into fears of a more aggressive Fed.
The Fed's policy-setting Federal Open Market Committee "is likely to send a modestly hawkish signal as FOMC officials become more convinced of the shift from the disinflation of 2017 and emphasize the momentum in the real economy," write interest rate strategists at Bank of America-Merrill Lynch in a research note.
That could hit equity prices, already under pressure this week from concerns over rising bond yields, although it could support a battered US dollar.
"We also expect the FOMC to alter the language around inflation expectations, particularly market-based measures," the BofA-Merrill note adds, citing a "decisive increase" in the gap between five-year notes and inflation-protected bonds of the same maturity, as pictured in the chart below. The Fed will release a statement following its two-day meeting at 2 p.m. ET Wednesday.
This is Janet Yellen's last meeting as Federal Reserve chair as she becomes the central bank's first leader in modern history not to be appointed for a second term after President Donald Trump decided to give the job to Fed Governor Jerome Powell. The Fed has raised interset rates five times since December 2015, after keeping them at effectively zero for seven years, to the current 1.25% to 1.5% range.
It has also started to reduce the size of its balance sheet by no longer reinvesting the principal on maturing bonds, which traders say is set to put further upward pressure on longer-term Treasury yields, which move opposite to their price.
Looking further ahead, the strategists expect the push toward higher yields to continue, which likely has bearish implications for stocks.
"Beyond this meeting, we believe rates across the curve are headed higher. The combination of easier fiscal policy, higher deficits, greater Treasury supply, and building inflation expectations should result in a further increase in five- to 10-year rates," they said.