Investors remain cautious ahead of the most highly anticipated Federal Reserve meeting. The Dow Jones Industrial Average declined 0.89 percent, the S&P 500 Index 0.91 percent, the Nasdaq 1.39 percent and the Russell 2000 Index 1.42 percent.
Sector performance confirms investors are playing defense. SPDR Real Estate (XLRE), Consumer Staples (XLP) and Utilities (XLU) each advanced on Monday with gains of 1.34 percent, 1.31 percent and 1.23 percent, respectively. SPDR Healthcare, which has defensive subsectors, gained 0.91 percent. The rest of the sectors were down on the day led by a 2.78-percent drop in SPDR Energy (XLE).
Equities started the day mostly flat, but then sold off after the New York branch of the Federal Reserve published its latest survey results. It shows consumers expect high inflation next year, with a quarter of them looking for double-digit inflation.
The question for markets this week is the extent which higher inflation is already priced in to the market. The headline indexes are near record highs with the S&P 500 Index closing at a new all-time high on Friday. In the bullish camp are seasonality and inflows. Year-end is a historically bullish period for equities. It also may be the case that many investors are nervous about the Federal Reserve meeting. One of the adages in the market is “sell the news.” In this case, bulls may be on the sidelines while bears open short positions ahead of the Fed meeting. This sets up a potential situation where stocks fall on Monday and Tuesday, and then rally if the Fed is less hawkish than the market anticipates.
The Fed has gone out of its way to avoid upsetting markets in the past. Instead of signaling concern with inflation, Federal Reserve Chairman Powell in November answered a question about high inflation by saying the bank was only concerned about long-run inflation. Officials reversed course almost immediately with a series of increasingly hawkish public comments.
It appears the Fed will end the taper in March. More than one official called for this and Powell seemed to agree without mentioning a specific date when testifying before Congress. We believe this is likely and such an announcement should spark a rally.
Speculators betting on Fed policy have the odds of a June rate hike at 75 percent. However, investment banks and analysts have been looking towards September. If the Fed is cautious, they might hint at a June hike. They will do this via the “dot plots” that show how many rate hikes Fed officials expect in the future. This doesn’t commit them to do anything, but it would signal they are moving slowly in a hawkish direction.
Oil is the key commodity to watch. Crude is highly correlated with movements in the CPI. It dipped on Monday to $71 per barrel, above last week’s low of $62 and below the 52-week high near $85 per barrel. If the Fed can get oil below $60 per barrel, the CPI should fall in early 2022 and that would allow the Fed to delay rate hikes.
Clearly, the Fed doesn’t want to upset markets, doesn’t want to hike rates too quickly or too soon, but also wants inflation expectations to come down.