Yesterday’s more hawkish than expected FOMC rate decision jolted previously sleepy markets into action. Before we discuss the lively market reaction and what comes next, a quick recap on events yesterday evening; as expected, the bank kept interest rates and the parameters of its QE programme unchanged. However, the newly updated dot-plot (essentially an aggregation of expectations from each Fed member as to where they think interest rates will be over the forecast time horizon) was more hawkish than expected, with the median dot signalling a total of 50bps of hikes by the end of 2023. Moreover, 7 dots see a hike in interest rates in 2022. This was more hawkish that expected. Meanwhile, as expected, the updated economic forecasts saw GDP and Core PCE (inflation) expectations get hefty upgrades to 7.0% from 6.5% and to 3.0% from 2.2% in 2021 respectively. Meanwhile and also as expected, Fed Chair Powell said in the press conference that the Fed had started “talking about talking about tapering”, whilst reiterating his stance that 1) high inflation is going to be a transitory phenomenon and 2) that the labour market remains a long way from where it needs to be.
Now returning back to the market reaction. The best place to start is with US bond markets, 5-year yields currently sit around 12bps higher than their pre-FOMC meeting levels at just under 0.9% and 10-year yields, whilst 10-year yields are up about 8bps, a reflection of bond market participants bringing forward interest rate hike expectations in response to the more hawkish than expected dot-plot rate path guidance. Real yields saw an even more extreme move to the upside; 5-year TIPS yields are up a staggering 22bps versus pre-FOMC levels at just under -1.5%, while 10-year TIPS have seen a roughly 18bps move to the upside and currently sit around -0.75%. The larger upside move in real yields versus nominal yields reflects the fact that markets have revised lower long-term inflation expectations. Judging by the reaction of inflation expectations, yesterday’s more hawkish than expected FOMC event appears to have 1) delivered a blow to the argument being pushed by the so-called “inflationistas” that the Fed may “lose control” of inflation by sitting too far behind the curve in terms of its eventual monetary tightening (which makes sense, given new Fed guidance has literally indicated hikes will now come sooner than previously forecast) and 2) sent a message that the Fed is not willing to tolerate quiet as much inflation as previously thought.
Turning to other asset classes, higher real and nominal yields have sent the US dollar surging; the DXY is at multi-month highs above 91.50 from previous levels around 90.50, which has sent EURUSD about 200bps lower to under 1.1950 and GBPUSD under 1.4000 and towards 1.3950 from previously close to 1.4100. The FX market move appears to have come in two waves, with the first part of the move of course happening as an immediate response to yesterday’s Fed event, but a further extension of dollar buying coming upon the arrival of European market participants this morning (their first proper chance to respond to yesterday evening’s events). In terms of other asset classes, stocks are unsurprisingly lower, with the S&P 500 having slipped back to the 4200 level from previously around 4250, a level it seems eager to cling onto for now, though some might argue that yesterday’s selling in stocks was not enough given the extent of the rise in yields. Crude oil prices, meanwhile, took a knock, but have now mostly recovered and are back to within not very far from yesterday’s pre-FOMC cycle highs (WTI has recovered from a dip to $71.50 and is back in the $72.00s). Highly monetary policy, US dollar and real yield sensitive gold has seen no such luck, unsurprisingly; in wake of yesterday’s FOMC event, gold prices have cratered down to towards the $1800 level from previously around $1860, a hefty decline but certainly one that is in proportion to the outsized gains seen in USD and US real yields (both of which gold has a strong negative correlation to).
Looking ahead, a key market driver in the coming weeks will be Fed speak, with markets wondering where the various Fed members on the most important monetary policy related questions, such as their expectations for growth, the jobs market, inflation and what the Fed’s reaction function to developments in the economy, a reaction function which markets continue to struggle to deduce in light of the bank’s newly adopted Average Inflation Targeting regime (a policy which means the Fed will allow inflation to “run hot”, but with the big question being how hot?). Fed speakers will be coming out of the woodwork on the 21st of June, a smart move by the Fed; wait and observe the market reaction to the FOMC meeting to give policy makers a chance to fine-tune how they are will attempt to guide markets via their communications.
In terms of what comes next for markets; market people will remember back in Q1 when serious talk of Fed policy tightening started to pick up for the first time in the post-pandemic era and as a result, US bond yields and the dollar strengthened. However, the Fed was keen to push back against this, dovishly emphasising that it was too early to talk about QE tapering and then dovishly stating that it expects any spike in inflation to be transitory in response to the pickup in inflation from March onwards. People betting that expectations for Fed policy divergence (i.e. monetary policy tightening earlier than other major central banks) would push the dollar and US yields higher back then appeared caught out, or to have gone for that trade too early. That experience, which was of course painful for some, seemed to instil a sense of patience in the market; “we know the Fed is going to tighten policy eventually (and almost certainly ahead of the ECB and BoJ etc.) as the economy improves, and that should push yields higher… but for now, we wait so as not to get caught out like the guys who went too early in Q1” seems to have been a commonly held view. Well, it appears the day has come, and the trade might have finally arrived. The Fed is now confirmed to be talking about talking about tapering, meaning a likely taper announcement later in the year. Meanwhile, though the Fed is not going to be at the front of the G10 central bank monetary policy tightening queue (that is the Norges Bank), it does seem to be positioning itself as one of the earlier tighteners (alongside the BoC, RBNZ and perhaps BoE). As a result of the above, I think it is a decent bet that 1) yields may maintain recent upside momentum and 2) the dollar may maintain decent upside momentum over the remainder of summer, though the next big driver will be 1) the Fed’s official decision to taper and 2) US data (with inflation and employment the most important, of course) – hotter than expected inflation and a faster than expected labour market recovery could make those dot-plots look even more hawkish by the end of the year.
Other market news
The Fed meeting and its aftermath is the dominant theme in the mind of most investors right now but there are a few other stories/market developments to note. ECB Chief Economist Philip Lane was out this morning seemingly in a bid to take the opportunity in wake of yesterday evening’s hawkish Fed to emphasise that the ECB is on a much more dovish policy normalisation path. This has not helped EURUSD’s case, with the currency sharply underperforming the likes of sterling this morning (euro is down a further 0.5% after yesterday’s more than 1.0% decline, versus GBPUSD which is down just 0.2% this morning). The Norges Bank and Swiss National Bank held policy unchanged this morning as expected, but this has not helped NOK or CHF, both of which are down a further 0.7% on the day versus USD this morning, with some speculating that the SNB has jumped on the opportunity offered by yesterday’s hawkish Fed to help along weakness in CHF. AUD, NZD and CAD are each down a further roughly 0.4% on the day versus the buck, with commentary from the BoC and RBA governors (the former was on balance more hawkish and the latter a little more dovish) not moving the needle for either the Loonie of Aussie. Australian labour market data for the month of May was also released last night and was significantly better than expected, though again, as was the case with RBA Governor Lowe’s comments last night, everything is playing second fiddle to the Fed right now. Moreover, on the topic of data, New Zealand Q1 GDP was out last night and was also significantly better than expected with growth on the quarter at 1.5% QoQ versus forecasts for 0.5% growth, but as with other non-FOMC related market news, this has not had much of an impact on NZD.
The Day Ahead
US weekly jobless claims and the June Philly Fed Manufacturing survey is out at 1330BST and then US Treasury Secretary Yellen will be speaking at 1500BST, where she may have comments on monetary policy (though she no longer has any say on it). The US equity cash open at 1430BST will be interesting; having had the chance to “sleep on it”, how will US equity traders interpret the implications of yesterday’s Fed meeting for stock prices/valuations. It could be a choppy session.