Here's Why The Stock Market May See A Fed Letdown

After months of hemming and hawing about this year's surprisingly tepid inflation data, it's time for Federal Reserve policymakers to put their cards on the table: Have they been transformed into doves, or are they sticking to their guns?

XThe likely answer may not please investors — unless they're piling into bank stocks, as more portfolio managers seem to be doing lately. On Monday, shares of Citigroup (C) broke above a 69.96 flat-base buy point to hit its highest level since January 2009. While other investing criteria are important, a breakout is often the precursor of further near-term gains.

The big news widely expected on Wednesday is an announcement that the Fed will gradually begin scaling back its $4.5 trillion balance sheet by letting $10 billion in principal run off per month, rather than reinvesting all proceeds of maturing Treasury and mortgage bonds.

But since that decision has been telegraphed for a couple of months, the real question for investors is whether anything has really changed since a majority of Fed members penciled in their expected trajectory of four quarter-point rate hikes between now and the end of 2018.


Here's the likely problem for markets: Back in June, 12 of 16 Fed committee members were projecting one more hike this year and three more in 2018. That means it will take four new doves to shift the Fed's hawkish consensus, which stands in sharp contrast to market expectations of just one more hike (in December) through August 2018, according to the CME Group FedWatch tool.

The upshot is that higher Treasury yields and lower stock prices are the most likely initial reaction to the Fed's announcement at 2 p.m. ET Wednesday. Yet Treasury yields have risen for six straight sessions through Monday, lifting bank stocks that have lagged the broad market all year.

Bank of America (BAC) also is making a run at a buy point. BofA, which rose 1.3% to 24.70 on Monday, has a 25.45 buy point in a base-on-base pattern. JPMorgan Chase (JPM) climbed 1.4% to 92.92, moving back above its 50-day moving average. JPMorgan has a 95.32 potential buy point.

IBD'S TAKE: IBD readers were ready for the stock market's push to record heights this month. On Aug. 22, IBD shifted its market trend gauge to "confirmed uptrend" from "uptrend under pressure," the equivalent of a flashing yellow light turning green. Read IBD's The Big Picture column each day to stay on top of the market direction, a key indicator that lets you know when you can be aggressive and when you should move to the sidelines.

A number of factors are combining to lift yields, including a stronger-than-expected consumer price index for August, the Fed's coming reinvestment shift and a flood of Treasury issuance, thanks to President Trump's deal with top congressional Democrats to lift the limit on government borrowing until Dec. 8.

Despite all the dovish talk as inflation undershot in recent months, four more doves may be too much to hope for, given that core inflation rose a shade under 0.25% on the month. Central bankers schooled to expect higher inflation to follow low unemployment may not be that quick to learn a new trick.

"In addition to the macro tailwind of higher rates, banks should benefit from regulatory changes that are currently not reflected in share prices," David Kostin, Goldman Sachs chief equity strategist, wrote in a note to clients.

Kostin said he expects markets to avoid another "taper tantrum," the name for the sell-off sparked by then-Fed Chair Ben Bernanke's signal in 2013 that the central bank would begin winding down its QE asset purchases.

Still, a "reinvestment reflux" could be in the cards, partly because the debt ceiling deal means that the Treasury Department needs to unwind all of the extraordinary measures it has taken since March — worth as much as $400 billion — when the government's authority to issue new debt ran out.

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