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What to Look Out For in the Fed Minutes

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Last Friday, traders got something of a worrying sign – and then kind of shrugged it off. The yield differential between the 2 year and 10 year US treasury bonds inverted for the first time since the start of the pandemic. This is significant because the yield curve inversion has successfully predicted a recession 10 out of the last 10 times.

That doesn’t mean a recession happens right away. The theory suggests that a recession could happen anywhere from six months to two years from now.

So, there isn’t necessarily any reason to start selling stocks. And it appears that the inversion isn’t likely to deter the Fed’s move to tighten rates.

How big of a deal is it?

The market is pricing in at least a 25 basis point rate hike at the next meeting. But now as many as 3 out of 4 analysts are suggesting the Fed could raise rates by 50 basis points.

A quick look at recent Fed officials’ comments shows that there are hardly any doves left. Yesterday, a noted dove Daly (non-voter) argued that the case for a 50 basis point hike in May has grown. Note that the Fed often uses non-voters as a ‘trial’ to see how the market might react to certain scenarios.

So, if even some of the most dovish members are talking about 50bps, let alone 25, a strong move higher in the rates is possible in the near term. The question is whether it will be all at once at the next meeting in May or some at the meeting in June.

Parsing the numbers

After the last meeting, the FOMC revised the so-called ‘dot plot’ matrix. That is when different members say where they expect interest rates to be. Up until that meeting, the matrix showed an average of three rate hikes for the rest of the year. After the meeting, that was moved up to seven.

From the minutes, we’ll get a better understanding of who voted for what, and what the rationale was for the revised forecasts. Although now that the Fed’s rate outlook is more in line with the market, the minutes are likely to have a smaller effect in terms of interest rates.

What could shake things up a bit is a discussion about the ‘runoff’ or the balance sheet. The Fed bought well over $4.0T in assets during the pandemic and will start the process of selling them back to the market. In turn, that would withdraw liquidity and help reverse some of the effects that the monetary expansion had on inflation.

The ‘recession trade’

If there is talk of a more aggressive shrinking of the balance sheet, that could have a bigger impact on stocks. That’s because the funds from the asset purchases, for the most part, supply liquidity to the market. That might mean investors would switch to stocks that have lower valuations with less debt. And these will be more resilient in the case of a downturn.

Generally, more rate hikes would translate into a stronger dollar. But a bigger runoff of assets by the Fed could depress the US stock market.

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