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Financial market participants eagerly await the outcome of another much anticipated FOMC policy meeting which will be released to the public at 1900BST on Wednesday the 3rd of November. Despite the fact that the Fed will not be releasing updated economic forecasts or a new dot plot, market participants are putting a lot of emphasis on this meeting given the bank is expected to finalise agreement on the timetable for the tapering of its QE programme. Fed officials, including Powell, have in recent weeks thrown their support behind a taper announcement at the November policy meeting, with Powell as recently as last Friday saying that the time to taper has arrived. Thus, an official taper announcement will not come as a surprise to market participants.
But there still remains some uncertainty as to what the exact taper timeline will look like. At the September FOMC meeting, Powell hinted it might be appropriate to conclude the taper sometime in mid-2022 and the minutes of that meeting showed that there was some chatter about a $15B per month pace of taper (taking eight months to taper net purchases to zero from the current levels of $120B per month). This is likely to be the market’s base case, though participants are still undecided about whether the taper will begin in November immediately after next week’s meeting or in December. Recent developments in the global economy – the spike in energy prices in September and October, signs of worsening supply chain disruptions and the subsequent sharp rise in market-based measures of global inflation expectations – and the resultant more worried tone from Fed Chairman Powell regarding the risk of more persistent inflation when he spoke last Friday suggest the risks are tilted towards an earlier start to the taper, as well as to a more aggressive pace of taper. Some analysts are calling for a $20B per month pace of QE taper and a November start, meaning net bond-buying would fall to zero by the end of April 2022.
A more hawkish approach to QE tapering is thus a risk to watch out for, but it seems the most important theme being watched by markets right now with regards to the Fed is the timing of the coming rate hike cycle. As the aforementioned pro-inflationary developments have unfolded in recent weeks and inflation expectations in the US (and other key economies) have flown to multi-year/decade highs, market participants have been bringing forward their bets as to when the Fed is going to start hiking interest rates. As of Friday the 29th of October, money markets are pricing a more than 65% chance that the Fed hikes rate by at least 25bps by the 15th of June 2022 meeting. That compares to much less aggressive pricing one month ago, where money markets priced a less than 25% chance of at least two hikes by the June meeting. Meanwhile, the money market-implied probability of the Fed having hiked by 25bps at least twice by the end of the year now stands at more than 80%, up from about 35% one month ago.
As noted, the flavour of Chair Powell’s comments on inflation when he spoke last Friday indicated he is growing more worried about upside inflation risks; he said that the risks are now tilted towards more persistent bottlenecks and thus to higher inflation, which he now sees lasting well into next year, while he also noted the growing risk of second-round inflationary effects as price and wage setters begin to expect unduly high rates of inflation in the future. Thus, Powell’s post-FOMC policy announcement press conference will be closely watched, where he is likely to reiterate these worries. Also, look for some tweaks to how the Fed sees inflation in its statement on monetary policy. At present, inflation is largely dismissed as transitory, but will likely be tweaked to reflect what the Fed now sees as a more elevated risk of a longer overshoot (note that core CPI remained above 4.0% in September and most economists expect it to remain elevated well above the Fed’s 2.0% target well into 2022).
A more hawkish tone from the FOMC in the form of growing concerns about inflation is likely to be read by markets as an endorsement of the recent hawkish shift in the money market pricing of future rate hikes. But participants will be on the lookout for something more specific from Powell. So-called “fringe” FOMC members (like Bullard) are typically happier to get specific with regards to what they think would be appropriate in terms of future Fed policy (i.e. on the timing of rate hikes etc.). But Core FOMC members (Powell, Clarida, Williams) generally hold their cards closer to their chests. A few months ago, Clarida talked about how he could see the conditions for a rate hike being fulfilled by the end of 2023. Obviously, a lot has changed since then; inflation risks are higher, and it has become much more obvious that while the pace of the recovery in the labour market has slowed, demand for labour is very strong. If Powell does not outright say that he thinks rate hikes starting from mid-2022 might be appropriate, look out for any indications that he thinks the Fed might have fulfilled its mandate for full employment by then, which implies that rate hikes could then be appropriate.
Recall that in the new monetary framework announced back in 2020, the Fed said it wants to have fulfilled both the inflation and employment parts of its mandate before starting to lift interest rates (rather than lifting interest rates in anticipation that it would soon meeting these mandates as has been the case in the past). Fed members already deem the inflation part of the mandate as having been met but look out for any “lowering of the bar” for the employment part of the mandate having been met. This could tacitly be seen as the Fed shifting the emphasis of policy towards the containment of inflation risks and away from helping the labour market recover (which has been the main emphasis since the pandemic). Remember that central banks need to maintain credibility and thus need to avoid the admission of making policy mistakes, so the Fed is not going to say, “we were wrong to be so dovish and focused on the labour market and given the sharp rise in inflation risks, we are going to have to be more hawkish”. Rather, they may try to argue that they can fulfil their employment mandate by mid-2022. This should be seen as a hawkish shift.
In terms of how markets might react to all of the above; the main thing to watch will be how money markets react. Pricing is already quite hawkish with hikes expected as of mid-2022, so the bar for even more aggressive repricing seems high. If the Fed does fail to trigger a hawkish repricing in money markets, this may be a good opportunity for those holding onto USD longs to take some profit. But some bond strategists are of the view that with monetary tightening having officially arrived in the form of a November QE tapering announcement (and expectations for rate hikes shortly thereafter), risks to short and long-term US bond yields lay to the upside. It does seem odd that long-term US real yields are currently close to record lows around -1.0%, even though markets are pricing rate hikes from the Fed as soon as next year. Even if the move higher in inflation expectations loses some momentum on a more hawkish Fed tone, a sustained move higher in long-term real yields may outweigh this and push long-term yields higher. This would likely be a dollar bullish; maybe not against the currencies of central banks that are even more hawkish than the Fed (like GBP, NOK and NZD), but likely against the currencies of central banks who are seen as “behind” the Fed when it comes to policy normalisation (like EUR and JPY). As for US stock markets, which are currently trading at close to record levels, a QE tapering announcement and nod to 2022 rate hikes is likely already in the price. Indeed, stocks were able to recover from the September’s mini correction despite, over the same time period, expectations for rate lift-off from the Fed being brought significantly forward, with focus in equity markets mostly on strong earnings (which has eased concerns about valuations being too high). The bar for a hawkish Fed to knock stocks from their perch seems high and as long as any post-Fed move higher in yields is not too disorderly, stocks are likely to remain supported.
