New Year, New Fed

The U.S. economy added 199,000 jobs in December.

In ordinary times that would be a solid print, but it was well below the consensus estimate of 450,000 jobs. It was also well below the 651,000 jobs added according to the household survey, which is the survey used to calculate the U.S. unemployment rate. The result was a mixed employment report with the headline jobs number disappointing while the U.S. unemployment rate fell from 4.2% to 3.9% (quickly approaching its pre-pandemic level of 3.6%). Another interesting aspect was the average hourly earnings component which showed wages rising by 4.7% year-on-year. That was above expectations and supports the view that inflation may be broadening.

The Centers for Disease Control and Prevention (CDC) said that Omicron cases may experience both a dramatic rise and fall.

Rochelle Walensky, the director of the CDC, said that the Omicron surge in the U.S. may be best visualized as more as an “ice pick,” with a dramatic rise and fall in cases similar to South Africa. At the end of 2021, South Africa decided to lift a midnight to 4 a.m. curfew on people’s movement as the country believes it has passed the peak of its fourth Covid-19 wave. The most recent wave coming as a result of the Omicron variant.

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Financial markets are off to a rough start in the New Year following the release of the December Federal Open Market Committee minutes. The release of the minutes is often watched closely by investors for insights into the Fed’s thinking, but rarely have the minutes been as market-moving as the recent release. The following statement is what surprised investors, “Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.”

That statement signals that the Fed is considering “dual tightening” by reducing the size of its balance sheet at the same time as hiking interest rates. Essentially the Fed will no longer consider balance sheet reduction as a substitute for a quarterly rate hike. The result is a rise in monetary policy uncertainty as investors consider a faster normalization of monetary policy than originally anticipated (see figure 1). That view was further solidified after the December employment report showed the U.S. unemployment rate falling from 4.2% to 3.9% and average hourly earnings rising 4.7% year-on-year.

This chart shows the U.S. Monetary Policy Uncertainty Index from 2017 to 2022 Year-to-Date.

With inflation running well above the Fed’s 2.0% mandate and employment quickly closing in on full employment, the Fed apparently believes that the economy is in solid shape with robust consumer demand and that it should begin to normalize policy to reduce the risk of persistent inflation. In order to do that, the Fed apparently believes it may need to use reductions in its balance sheet to drive long-term rates higher so that it can avoid a flattening of the yield curve. Although one must wonder how impactful the Fed can be in reducing inflation with a notable portion of inflation likely being driven by supply chain disruptions (see figure 2).

This line chart shows the U.S. ISM Manufacturers’ Backlog of Orders and Prices Paid from 2012 to 2022 Year-to-Date.

The Market Expects a Rate Hike in March; Value Outperforming

The March FOMC meeting is now a live meeting with the odds of a rate hike in March having jumped to 92% and investors now waffling between three or four rate hikes in 2022. Wednesday’s release of the December consumer price index may help settle this debate with the consensus expecting prices to rise by 7.1% year-on-year. While not our base case, a weaker report could possibly reduce expectations for a fourth rate hike in 2022. It is not yet clear what the path of balance sheet reduction might take, but Citi Research’s economists believe that balance sheet reduction may commence in July.

This more hawkish tilt has weighed on U.S. stocks with the S&P 500 down 1.9% and the interest rate sensitive NASDAQ down 4.5% in the first week of January. This comes on the back of a sharp rise in yields with the 10-year U.S. Treasury yield surging from 1.51% at year-end to 1.76% by January 7th. Value stocks on the other hand, which are considered to be less sensitive to rising yields and include sectors like Energy and Financials, have been on the rise and finished the week up 1.0%. Remarkably, the S&P 500 Energy sector surged 10.6% last week and the S&P 500 Financial sector jumped 5.4%. We don’t think that these sectors are the best place for long-term growth, but both are positively correlated with higher interest rates and have been a strong hedge to date. Since the start of December 2021, U.S. Value stocks have outperformed U.S. Growth stocks by nearly 19.0% (see figure 3).

This line chart shows the S&P 500 Value vs. Growth Indices’ Returns Since December 2021 (%) from November 11th 2021 to January 10th 2022.

The Fed’s Path Could Still Change

The Fed’s hawkish pivot has clearly surprised investors, but we would note that the Fed’s projected policy path is not a static one and will likely still be dependent on the outlook for both growth and inflation. Should inflationary pressures start to ease in the first half of 2022, then some of the building pressure on the Fed to act may find a release valve. While unconventional monetary policy warrants caution, we still think there’s a chance that this tightening cycle ends up being moderate and that positive economic growth and equity market returns remain possible over the next couple of years. Citi’s Global Investment Committee stands firm on its strategy of favoring higher quality, larger and more profitable firms in stock holdings. That includes holdings in Dividend-Growers, Healthcare, and Consumer Staples. Please see our CIO Strategy Bulletin | The Market Loses the Fed's Tailwinds for additional portfolio insights.

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