The Chief Investment Office does not believe the Fed will need to crush growth to squeeze out inflation. (ddp)

Following the Fed’s policy-setting FOMC meeting, Powell refused to rule out a faster pace of rate rises or moving in larger increments. He added that inflation pressures had intensified since the central bank’s December meeting. Aside from depressing equities, his comments contributed to the largest one-day rise in 2-year US Treasury yields since the whipsawing trading of March 2020.

But despite Powell's hawkish tone and the risk of accelerated tightening, we don’t expect the Fed’s actions to derail growth or end the equity rally:

1. The Fed stressed that the US economy was strong enough to handle higher rates. A consistent theme of Powell’s press conference was that the “economy no longer needs sustained high levels of monetary policy support.” He described the labor market as “tremendously strong” and said growth was on track to remain well above trend. Despite a near-term drag on growth from omicron, the data bears out this assessment, in our view. Investor attention will shift now to the January US employment release next week, with a consensus expectation for an acceleration in employment and wage growth.

2. Investors remain confident in the Fed’s ability to keep inflation anchored, limiting the need for more aggressive tightening further out. Powell has shifted his message on inflation in recent months, going from considering it “transient” to acknowledging that it has remained elevated longer than expected. However, Wednesday’s rise in 10-year yields was driven by real yields, with a slight drop in market-based inflation expectations. This suggests that the Fed’s hawkish shift is bolstering its credibility in maintaining price stability and helping prevent higher inflation expectations from becoming entrenched.

3. Powell emphasized again that policy would be data dependent and that officials remained sensitive to risks to growth from the pandemic or geopolitical conflicts. The Fed Chair said that policy would be “humble and nimble.” Markets on Wednesday appeared to take this to mean that the Fed could accelerate rate rises if inflation proves higher than expected. But the "glass half full" interpretation is that this comment keeps open the possibility that the pace of tightening could slow if needed.

So, we do not believe the Fed will need to crush growth to squeeze out inflation. As a result, we advise investors to stay cyclical, with the energy sector and Eurozone equities among the winners from robust global growth. We also recommend investors prepare for rate rises, both in their equity and in their fixed income holdings. In equities, rising yields should favor value versus growth sectors, with financials a particular beneficiary of higher rates. In fixed income, US senior loans offer an attractive 4.4% yield, while their variable rate structure provides protection from higher rates.

Main contributors -Mark Haefele, Christopher Swann, Vincent Heaney, Brian Rose

Content is a product of the Chief Investment Office (CIO).

Original report - Tougher Fed unlikely to derail growth or the equity rally, 27 January 2022.