Markets May Be In For A Giant Shock Next Week

This article was written exclusively for Investing.com

Next week could be huge for markets with Wednesday's December FOMC meeting and press conference. Expectations have been building that the Fed will accelerate the tapering process after Chairman Jerome Powell provided testimony to Congress. At this point, it seems like the stock market is giving the Fed the green light to do what it needs to do.

Let's hope that is the case. Because if this turns out to be a game of chicken, the market may find itself in a precarious spot because the Fed may call the market's bluff. 

A Faster Taper?/h2

At this point, it seems highly likely that the Fed will accelerate the tapering of its asset purchases. In recent weeks, a number of Fed governors have come out calling for an accelerated tapering process, with some indications suggesting the process ends by March.

Equities initially sold off when markets first learned of this proposal. However, this past week, equities have soared back, coming within a stone's throw of their previous highs 

Perhaps the initial sell-off was muddied by headlines of a new coronavirus strain. But bonds and the Fed Federal Funds futures seem to be taking the threat from the Fed very seriously, with the 2-year rate moving from around 50 bps on Nov. 19 to nearly 70 bps. The rise has helped to flatten the yield curve dramatically, with the spread between the 10-year and the 2-year falling from 1.04% on Nov. 19 to just 80 bps. 

Additionally, the odds of the first-rate hike have been increasing, with the May Federal Funds futures climbing from around 18 bps to 25.5 bps. At the same time, the June Fed Fund futures have also risen from 23 bps to roughly 32 bps. Suggesting the market is now pricing in rate hikes much sooner than previously expected. 

Is The Fed Bluffing?/h2

The equity market almost seems to think the Fed is just bluffing and not choosing to accelerate the taper. The S&P 500 dropped from around 4,700 on Nov. 19 to a low of 4,495 on Dec. 3. But this week has been anything but stressful for equities, with the index rocketing higher by around 4%.

So if the equity market was concerned about the threat of an accelerated taper, it sure does have a funny way of showing it. It is also hard to imagine that with 2022 earnings estimates expected to grow by less than 10% and the S&P 500 trading at more than 20 times its next-twelve-months earnings estimates, an accelerated taper has been priced into the market. 

It seems to lead one to believe that the stock market may not think the Fed will taper faster, and in a way, may be daring the Fed to do it. But it seems highly unlikely, given the strength of the job report last week and the high inflation rates, that the Fed is bluffing and is probably very eager to get the taper over with as soon as possible. 

The equity market may very well be playing a giant game of chicken with the Fed. It doesn't feel like the greatest of strategies at the moment and one that could be rather painful if the equity market is entirely wrong. 

Come Wednesday; we will find out one way or another; who will blink first.

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Written By: Michael Kramer