Tuesday, October 19, 2021
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Traders on the floor of the New York Stock Exchange.

Source: NYSE

Monday’s aggressive stock market rally came despite the fears of one Wall Street firm that investors still aren’t appreciating how quickly the Federal Reserve could start raising rates.

After getting hammered in the final three trading days last week, Wall Street came roaring back with a move that sent the Dow Jones Industrial Average up more than 1.5%.

“The market is getting back to its comfortable mode,” Mohamed El-Erian, the chief economic advisor at Allianz, told CNBC’s “Squawk Box.” “Growth is strong. They still believe inflation is transitory. They believe the Fed is going to be relatively slow in tapering [monthly asset purchases], and that’s why you’re seeing” stocks higher.

That sanguine view of Fed policy is a mistake, according to Bank of America credit strategist Hans Mikkelsen.

Last week’s Federal Open Market Committee concluded with officials indicating they now see two rate increases coming as soon as 2023, more quickly than the market had been anticipating.

But Mikkelsen’s view is that tighter monetary policy may come even sooner.

“Expect the Fed to soon begin tapering its [quantitative easing] purchases, and to start hiking interest rates earlier than expected – and most importantly much faster than currently priced in markets,” he said in a note to clients.

The bank’s analysis noted the committee was only “two dots,” or the projections of two members of the 18-person committee, away from pulling the first rate increase into 2022. The panel split evenly on whether rates should move next year, while eight members saw as many as three hikes for 2023.

Taken collectively, the members’ sentiment about where policy should go offered a significant deviation from what has been a historically easy Fed.

Mikkelsen said the credit market, which sent rates sharply lower despite the hawkish Fed, is misjudging which way the central bank is heading. From the market’s perspective, it is seeing just a 41% chance that the Fed hikes rates by July 2022, according to the CME’s FedWatch tracker.

“The key mispricing in the rates market, as our rates strategists continue to point out, is not the taper, not the timing of the first rate hike, but the pace of hikes from that point on, which is way too shallow compared with normal hiking cycles in the past,” he wrote.

Mikkelsen pointed out that the Fed in effect has already begun tapering with its moves to unwind the small portfolio of corporate bonds it purchased during the Covid-19 pandemic. That move, “which was 100% unexpected as the Fed has a poor track record selling assets – was a signal the Fed increasingly feels emboldened to exit their super-easy monetary policy stance, even if that means defying market expectations.”

Changes in the Fed

For example, he cited changes in the energy industry – a key component of Kaplan’s district – toward sustainable power as contributing to longer-lasting inflationary pressures.

Bullard spoke of the evolving labor market as an important consideration for future Fed policy.

“We have to be ready for the idea that there’s upside risks to inflation,” he said. “Certainly, the anecdotal evidence is overwhelming that this is a very tight labor market.”

If those inflationary pressures are hotter than Fed officials think, it would force them into tightening policy faster than they would like. That would hit the stock market and broader economy, both of which are dependent on lower rates.

A tight Fed would drive up borrowing costs for a government that has been on a spending binge over the past year and wants to do even more with infrastructure.

“Right now, inflation is transitory. But if you overlay that with significant further stimulus, then you run the risk of making something transitory permanent,” Natixis chief economist for the Americas Joe LaVorgna said. “So, you’re in a really tricky spot. I think the Fed’s best approach is to say less.”

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