Tomorrow is "FED day", understood as the day in which the US Federal Reserve announces the monetary policy decision after the 2-day meeting that began today.
As I wrote in this journal in September, the FED already mentioned in its monetary policy statement at the end of July that, to begin the reduction of its bond purchase program of USD80,000 million and USD40,000 million per month in Treasuries and MBS respectively (decrease process known as "tapering"), their inflation criterion had already been met and that they only needed to see advance in the employment one. At that meeting, the FED board observed the variation of the PCE Index in 12 months at 3.9% and the unemployment rate at 5.9%. Now the variation of the PCE index is 4.4% per year and the unemployment rate is 4.8% (as of September), and therefore, there is higher inflation than the one had already satisfied the FED and an unemployment rate substantially lower than the one they saw when they commented on these variables in July.
Evolution of the 12-month variation of the PCE Index in US (inflation seen by the FED). Last reading for September was 4.4%
Evolution of the unemployment rate in the United States (last 5 years). Last reading of 4.8% (September)
The last monetary policy meeting was on September 22nd and, from the minutes of that meeting, I highlight the following comments:
"Consumer price inflation in June and July—as measured by the 12-month percentage change in the personal consumption expenditures (PCE) price index—was elevated..."
"The staff interpreted recent inflation data as indicating that supply constraints were putting a larger amount of upward pressure on prices than previously anticipated; relative to the July projection, these supply constraints were also expected to take longer to resolve. As a result, the 12-month change in PCE prices was projected to hold roughly steady over the remainder of 2021 and to end the year well above 2 percent."
"The staff also continued to judge that the risks around the inflation projection were tilted to the upside, with the possibility of more severe and persistent supply issues viewed as especially salient. In addition, the staff pointed to a risk that longer-run inflation expectations would move appreciably higher and lead to persistently elevated inflation."
"Participants reaffirmed that the Committee’s “substantial further progress” standard regarding its asset purchases was distinct from the criteria given in its forward guidance on the federal funds rate and that a policy shift toward a moderation of asset purchases provided no direct signal about its interest rate policy"
Considering the aforementioned, on the "roughly steady" 12m change in the PCE price index over the remainder of the year expected by the FED in its previous meeting, Powell faces a new Committee with a variation greater than the one of the previous meeting. Regarding the risks of inflation expectations, the inflation rate expected by the "breakeven" rate (spread between TIPS and nominal bonds), the FED made this comment with a 5-year breakeven of 2.48 % per year (value of September 23th), and that rate reached 2.99% on October 26th and is now at 2.86%.
Inflation expected by the 5-year breakeven (last week it reached the highest value on record)
The market has internalized that the FED would announce the "tapering" tomorrow and that, with this decrease, the asset purchase program would end in June or July 2022 (that is, the market is assuming that the FED lowers its program by USD15.000 millions per month beginning in mid-November or mid-December). The market also assigns a high probability that the FED's first rate hike would be in July of next year.
However, considering that not only current inflation but also the inflation expectations that the FED is seeing in this meeting are substantially higher (in addition to the much lower unemployment), it is reasonable to assign a certain probability to a statement that is perhaps more "concerned" than the one the market expects. The FED mandate is an average inflation of 2.0% per year and today it is at 4.4% and the 5-year expectations are almost at 3.0%, and with an upward bias and they have an economy close to full employment. Looking at this scenario, it seems that whatever the Committee says tomorrow, the Fed is in kind of a "chinese shoe". If the FED continues to maintain that inflation would be "transitory", it runs the serious risk of continuing to lose credibility, that is, if it continues with a "relaxed" policy regarding inflation, it would continue to help create even more inflation expectations, which could cause an even more pronounced rise in nominal rates in the short end of the curve in the coming days, more inflation expectations and, probably, a continuation of the uptrend in the cyclical stocks of the market. If it takes a more "worried" tone, it will feed the expectations of a short-term rate hike, but it would help to anchor inflation expectations and, probably, a stock correction could be generated (of the entire market, but especially of the "growth" stocks). I lean towards the last alternative.
Whatever happens tomorrow, the extremely high valuation levels (Shiller's CAPE at 40x in the S&P500; the most emblematic case of overvaluation is TESLA, which trades at ¡¡¡26x¡¡¡ its market cap over the NTM sales), the very high levels of speculation in options (the US stock market is in the highest decile of speculation in history), the low implicit volatility of the market (VIX), the positioning of investors ("all in" mode), in a context of a downtrend in global growth with rising inflation and rising short and medium term interest rates, as well as withdrawals of fiscal and monetary stimuli, they generate a special recipe for a correction in the S&P500.
A disclosure: if I think that the stock market would have a correction, that doesn´t mean that I do not see buying opportunities "within" the market. The S&P500 is an index of 500 stocks and several of its components I believe will perform well in the coming months and years. I also see stocks and ETFs from other countries where I think there are excellent opportunities. If you want to know more about these ideas, I invite you to subscribe to "The Speculator's Picks", by clicking on the link below, where you can find my investments thoughts about specific instruments (they are not buy or sell recommendations).
We'll see what happens tomorrow. Thanks for your attention.
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