What to Expect When You’re Expecting the FOMC (July 2021 Edition)

In case this week’s barrage of large company earnings releases does not provide enough excitement for investors, we have a Federal Reserve announcement this afternoon. The Federal Reserve Open Market Committee (FOMC) meets every six weeks, and as one might expect, those meetings are widely anticipated. While it is obvious that monetary policy is a crucial input to asset prices, and that the press conference from the Chair can provide important clues to the direction of that policy, investors may be surprised to learn that equity markets are frequently not pleased by what they hear in the immediate aftermath of these meetings. 

The table below makes that performance plain. It shows the 3-day performance of the S&P 500 Index in the three-day period surrounding all the FOMC meetings since the Covid crisis. This updates a table that we published prior to the last FOMC meeting:

Source: Bloomberg

As I see it, the most important takeaway is this: Despite a steadily rising market, after 9 out of 11 FOMC meetings, SPX was lower 2 days later – sometimes substantially. It is clear that investors like the overall message from the Fed, just not immediately. This indicates to me that traders tend to get ahead of themselves immediately before an FOMC meeting. They expect — and get — a dovish Fed, but their expectations often run ahead of the comments that follow the meeting. Overall, I believe that this shows that Chair Powell has figured out how to keep markets moving forward while keeping the most exuberant expectations in check.

Will this trend continue today? It is impossible to say for sure. There is no shortage of questions that the FOMC and Chairman must address today, including, but by no means limited to:

• Where do we stand relative to the Fed’s stated preference for sustained 2% inflation and full employment?
• Does the Fed expect to continue its current pace of balance sheet expansion?
• Does the Fed still believe that inflationary pressures are transitory? If so, what might cause that view to change?
• How does the anecdotal evidence about the difficulty in hiring labor fit in with the higher than desired unemployment rate?
• Will it cause inflation to achieve full employment?
• Does the resurgence of the Delta variant create economic headwinds that bias the FOMC towards a continued easy money policy? If so, how worried about the economy should we be?
• Amidst the double-digit rises in home prices, is the Fed giving any thought to tapering its purchases of mortgage-backed securities?
• Does the staggering rise in daily reverse repo activities give the FOMC any second thoughts about the sustainability of adding liquidity through balance sheet growth while simultaneously draining it through reverse repos?

If I were in a position to ask questions, the last one would be my choice. All of them are valid, but I find the rise in reverse repo activity to be particularly odd. Reverse repos are a tool that a central bank can use to absorb excess liquidity from banks and other financial market participants. In this case, the New York Fed sells a security to an eligible counterparty with the agreement to repurchase that security at a specified price at a specific time in the future. In exchange for the security it sells, the Fed receives cash. This temporarily takes money out of the financial system. The following chart shows how much the reverse repo activity has increased during the past few months:

(Click on image to enlarge)

Source: Overnight Reverse Repurchase Agreements: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations (RRPONTSYD) | FRED | St. Louis Fed (stlouisfed.org)

We saw occasional peaks around the end of calendar quarters, as banks tried to minimize the excess cash on their balance sheets ahead of quarterly and annual reports, but the sustained level of activity is extraordinarily unusual. I draw the following analogy: the Fed has been filling a swimming pool with cash but is now forced to run a pump on the other end to prevent it from overflowing. The analogy is imperfect, but it is curious, if not illogical, to sustain an activity of that type.

I see the following general consensus heading into the meeting: now that the Fed has moved beyond thinking about talking about tapering its bond purchases to actually talking about them, we expect to hear some clarification about the timing and pace of future tapering operations. Few expect a formal announcement today, though investors will be trying to discern whether that might come at the September FOMC meeting or next month’s Jackson Hole conference. We will soon see if the Chairman’s message fits with the market’s consensus viewpoint.