The Federal Reserve is more likely to say something to disappoint investors than to excite them at its meeting Wednesday. That, on its own, is a negative for stocks.
The Fed is expected to give guidance on the path of its bond-buying program in its Wednesday statement. The central bankâ€™s $80 billion of monthly Treasury purchases have raised bond prices and sent yields lower, pushing investors into riskier markets, like those for corporate bonds and mortgages. This powerful stimulus has been a major catalyst in bringing the S&P 500 up 64% from its bear-market low on March 23.
That has some on Wall Street, such as Citigroup economists, warning about the risk that the Fed will disappoint. Stocks may face pressure if Fed officials hold off on buying more long-term Treasury bonds, the group of economists wrote in a recent note.
â€œA still-very-accommodative Fed may disappoint some market participants who expect ever-easier policy,â€ they said. The economists noted there is a 25% chance that the Fed extends the average maturity of its Treasury purchases at its meeting this week.
Others agree. Marc Pfeffer, chief investment officer at CLS Investments, is concerned about the possibility that the Fed will disappoint. â€œGiven where the market is, thereâ€™s more risk skewed toward having a negative [market] reaction than a positive reaction,â€ Pfeffer told Barronâ€™s.
High valuations are one reason stocks are vulnerable. The average stock in the S&P 500 trades at just above 22 times next yearâ€™s earnings per share projections. Thatâ€™s much higher than the average in the past five years of just above 17 times earnings forecasts. Many strategists and investors call current valuation levels stretched. â€œThings [in stocks] are certainly bubbling higher,â€ which means stocks have more downside than upside upon new Fed comments, Stan Sokolowski, deputy chief investment officer at CIFC Asset Management, told Barronâ€™s.
Low interest rates and Treasury yields bring about higher stock valuations because they push investors into riskier assets. Similarly, companiesâ€™ future cash flows are more valuable when rates are lower and less valuable when rates rise. And while the central bank has said short-term interest rates will likely remain low through 2023, long-term Treasury yields have been rising in recent weeks, driven by improving expectations for growth.
Some on Wall Street are starting to doubt the Fedâ€™s willingness to ease policy much more from here.
The Fed has assured investors that it wonâ€™t cut interest rates below zero soon. The benchmark short-term lending rate is 0% and the 10-year Treasury yield is just above 0.9%, far below the expected inflation rate of just under 2%.
Thatâ€™s a positive for stocks. Other options, such as Treasuries, are unattractive when their interest payments lose value against inflation. Unfortunately, that is also priced into the stock market, and now yields are more likely to creep upward towards the inflation rate than to fall much more below it.
At their last meeting, Fed officials discussed providing guidance about when they will start to wind down bond-buying effortsâ€”and said that they expect to stop their Treasury purchases well before they raise rates, which could happen by the end of 2023. Some on Wall Street have flagged that as a potential negative for stock valuations.
Still, CLSâ€™s Pfeffer said that if the Fed pulls back on stimulus in the coming year, it would likely be a reflection of a strong economy that is conducive to further strength in near-term earnings, which would support stocks.
And the Fed could still surprise markets by saying it will increase the size of its program as Covid-19 cases surge. Just donâ€™t expect stocks to explode higher after the Fed releases its statement Wednesday.
Write to Jacob Sonenshine at firstname.lastname@example.org