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The beginning of the end of ultra-cheap money

Five things that could tank the market

U.S. equities wound up nearly unchanged on Wednesday, despite some volatile trading, after the Federal Reserve announced it would begin winding down its bloated $4.4 trillion balance sheet in October. This "quantitative tightening" will start off slowly, at just $10 billion a month before increasing every three months to a $50 billion monthly pace.

The Fed has a long way to go if it's going to return to its pre-crisis balance sheet of less than $900 billion. 

In what could be considered a hawkish outcome, Fed officials also stuck to their expectation of another interest rate hike in December. In her post-announcement press conference, Fed Chair Janet Yellen admitted that the tepid behavior of inflation was puzzling, but she maintained a focus on evidence of labor market tightness -- something that historically has been a strong antecedent of "wage-push" inflation pressure, in which rising wages spark a cycle of rising inflation.

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The short-term Treasury bond market is behaving in a typical manner in this environment: Interest rates are pushing up to levels not seen since 2008 (chart above) in anticipation of tighter monetary conditions and higher inflation -- which is the outlook the Fed maintains.

Other markets, however, are acting like this is a policy mistake. Or that the Fed won't be able to stick to its guns on its rate hike expectations into 2018 and 2019, with a trio of quarter-point hikes penciled in for next year. The failure of long-term Treasury bond yields to decline as one would expect is a sign of that market sentiment.

Bank stocks didn't seem to care, however, as the market's Teflon enthusiasm remains intact. It has been more than a year since investors had to suffer the ignominy of a 10 percent market correction.

The path forward for the Fed depends in large part on what inflation does. History suggests that inflation can quickly and unexpectedly manifest from a tight labor market, as it did in the 1960s. In 1964, core inflation (excluding food and energy) was running at a 1.7 percent rate and dropped to just 1.2 percent in 1965 amid a 4.5 percent unemployment rate, same as today. 

But by the end of 1966, inflation was out of control and didn't fall back below 2 percent again until nearly 30 years later.

Last month's Consumer Price Index data points to a possible reacceleration in prices: The year-over-year rate increased to 1.9 percent, thanks largely to a surge in housing costs. Fed officials expect this upward momentum to continue even as economic growth slows as the cost of borrowing goes up.

 

 

 

 

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