The Federal Reserve at its policy meeting on 16th June, whether inadvertently or by design, reset financial markets’ clocks.
The dust has since settled somewhat, with US short-end and long-end yields, the US Dollar and S&P 500 trading sideways for the past couple of sessions. When looking at the past month, hawks, doves, bulls and bears can all claim at least a partial victory.
The million Dollar question remains when the Federal Reserve will start tapering its asset purchases and hiking its policy rate. FOMC members will undoubtedly try to refine their thoughts in coming weeks, as will Chairperson Powell today in his testimony before the Joint Economic Committee.
But the next big hurdle for markets is Friday’s release of PCE-inflation data for May.
Markets in May glided past US inflation data releases largely unscathed, in line with our forecasts, but the financial landscape has undergone a paradigm shift in the past week.
Our view is that that unless PCE-inflation in May surprises materially to the upside, US short-end yields may retrace somewhat and the Dollar give back some its recent gains – but this is admittedly not a high conviction call.
The Federal Reserve’s anonymous dot-charts have their limitations but for now we are sticking to “our core scenario that the Federal Reserve will only start tapering its monthly asset purchases in 2022 and only start hiking its policy rate in 2023”.
We also think that that the gap between the start of the taper and the start of the rate hiking cycle will likely be materially shorter than the 24 months gap in 2013-2015.
Our next FIRMS report will focus on Sterling and Euro which are drawn level as we approach half-time. Sterling has at the margin dominated the encounter in the past month, with the GBP/EUR cross currently trading around 1.168 – the upper half of a still depressingly narrow 18-week range of just 2.7%. We think Sterling will continue to slowly pull ahead in Q3 before losing steam in Q4.
Big percentage changes, appropriate levels?
Quasi-dormant US financial markets have come to life since last Wednesday’s Federal Reserve policy meeting.
Perhaps most notably the updated “dot-chart” now has a majority of FOMC members (13 out of 18) expecting that at least one policy rate hike of 25bp would be appropriate by end-2023 (rather than by end2024). We would flag erroneous reports that a majority of FOMC members now expects the Federal
Reserve to start hiking its policy rate in 2023, noting that 7 out of 18 members (just three short of a majority) think it would be appropriate for the Federal Reserve to deliver at least one 25bp rate hike in 2022. Moreover, Chairperson Powell said in his press conference that the Federal Reserve was “talking about talking” about tapering its QE program.
This (implied) policy shift was arguably in response (at least partly) to upwardly revised 2021 forecasts for inflation and GDP growth. This was in turn the result of higher-than-expected inflation and growth year-todate and, based on the accompanying policy statement, a more bullish outlook for the US vaccination program and economy for the rest of the year.
The aggregate impact has been clear-cut. US 2-year Treasury yields, which had already risen 1.5bp on 14- 15 June, have jumped a further 8bp to 0.246%, near their highest level since the beginning of the pandemic in March 2020 (see Figure 1).
Figure 1: Dollar, weighed down by low-end rates in past 15 months, has rebounded in line with 2-year yields
Source: 4X Global Research, Federal Reserve, investing.com
This jump in short-end yields and Dollar-carry resulted in the safe-haven Dollar closing up about 0.8% on 16th June according to our calculations, the largest daily gain in the Nominal Effective Exchange Rate (NEER) since late-September (see Figure 2). The Dollar NEER has since appreciated a further 0.8% to its strongest level in over two months (see Figures 1, 3 and 5).
Figure 2: Dollar NEER closed up 0.8% on 16th June, its largest daily gain since 23rd September 2020
Daily % change in US Dollar Nominal Effective Exchange Rate, Federal Reserve trade weights (closing prices)
Source: 4X Global Research, Federal Reserve, investing.com
The Dollar NEER has remained inversely correlated with the S&P 500 (see Figure 3). However, while the Dollar NEER has appreciated about 1.5% since 15th June (the day before the Federal Reserve policy meeting) the S&P 500 has weakened only 0.5% and is down only 0.7% since the record-high posted on 14th June. Equity markets are seemingly taking the view that a combination of strong US economic growth and still very loose monetary policy and financial conditions are ultimately supportive.
Figure 3: S&P 500 sell-off has been less acute than US Dollar rally
Source: 4X Global Research, Federal Reserve, investing.com
More today, less tomorrow – Fed anchors inflation expectations and long-end rates
However, the Federal Reserve only made very minor changes to its 2022 and 2023 forecasts for US inflation, GDP growth and employment, with the Federal Reserve sticking to its long-held view that the rise in US inflation will prove transitory. Moreover, based on our calculations using weighted-averages of FOMC members’ “dots”, the Federal Reserve also kept its terminal point for the appropriate policy rate unchanged (see Figure 4),
Figure 4: FOMC members’ appropriate terminal policy rate remained unchanged at June meeting
Source: 4X Global Research, Federal Reserve
Price action in the long-end of the US Treasury curve and market-derived inflation rates suggests to us that markets have gone one step further.
- The benchmark US 10-year Treasury yield closed 9bp higher on 16th June but has since fallen 9bp to 1.487% at time of writing. The bearish flattening of the US rates curve has been pronounced, with the 2s-10s US Treasury yield spread narrowing 10bp to 122bp (see Figure 5).
- The 5-year breakeven inflation rate, a market measure of expected inflation in 5 years time, has fallen 27bp from a 13-year high of 2.68% on 14th June to 2.41% on 21st June.
- The 5-year, 5-year forward inflation expectation rate has fallen by a similar magnitude, to 2.09% on 21st June from 2.34% on 14th June.
Markets have seemingly taken the view that a “front-loading” of Federal Reserve policy rate hikes will result in lower US inflation medium-term and in fewer total rate hikes being required (or put differently that the terminal point for the policy rate will be lower than it would have been had the Federal Reserve ignored recent macro data and stuck to an ultra-dovish outlook for monetary policy).
Figure 5: Rise in 2 year yields half the story, fall in 10-year yields the other half
Source: 4X Global Research, Federal Reserve, investing.com. Note: *10-year Treasury yield minus 2-year Treasury yield
Back to the data….
The magnitude of these US market moves clearly points to the Federal Reserve’s hawkish shift having caught US short-end rates, Dollar and equity markets off guard. We ourselves admit to having been complacent to the risk of the Federal Reserve dialling back its dovishness.
Whether markets’ reaction was commensurate is arguably a case of how long is a piece of string. Doves would argue that the Federal Reserve’s hawkish tilt was not surprising and that markets have over-reacted.
At the other end of the spectrum, hawks would argue that the bounce in short-end rates and US Dollar and correction in equities was well over-due and that levels now better represent the current macro backdrop and likely outlook for US economy. We have a degree of sympathy with both views (at the risk of being accused of sitting on the fence).
In any case the million Dollar question remains when the Federal Reserve will start tapering its asset purchases and hiking its policy rate. FOMC members will undoubtedly try to refine their thoughts in coming days and weeks, as will Chairperson Powell today in his testimony on the economic outlook and recent monetary policy actions before the Joint Economic Committee.
Future policy meetings will help fill in some of the blanks, while key US macro data releases will also colour the Federal Reserve and markets’ thinking. These include the release of May Personal Consumption Expenditure (PCE) inflation data on Friday 25th June at 13.30 (London time). Core PCE-inflation, which strips out more volatile food and energy prices and is the Federal Reserve’s preferred measure of inflation, rose from 1.9% yoy in March to a slightly higherthan-expected 3.1% yoy in April, well above the Federal Reserve’s long-term target of 2%. The consensus forecast is that core PCE-inflation rose to a 20-year high of 3.4% yoy in May. Note that even if this estimate proves accurate, the 12-month rolling average in May of 1.7% yoy would still be below the Federal Reserve’s 2% target (see Figure 6).
Given the Federal Reserve’s asymmetric monetary policy framework, which effectively aims to foster temporary inflation overshoots following periods of inflation-undershoot (see US: Much ado about nothing, 28th August 2020), we would not expect a further rise in PCE-inflation in May to lead to another material shift in the Federal Reserve’s overall rhetoric in the very near-term. Whether US financial markets will feel the same way on Friday is debatable. Their hawkish reaction to higher-than-expected PCE-inflation and CPI-inflation data, released on respectively 28th May and 12th May, was modest and short-lived, in line with our expectations (see Tantrum “lite” won’t help US Dollar, 28th May 2021, and US markets playing along to Fed tune…for now, 14th May 2021).
Figure 6: Consensus forecast is that core PCE-inflation rose to 3.4% yoy in May – will Fed/markets now care?
Source: 4X Global Research, Bureau of Economic Analysis, Federal Reserve
However, last week’s Federal Reserve policy meeting, while well short of revolutionary in our view, has arguably led to a paradigm shift in markets’ thinking. Put differently, the world – at least with regards to US financial assets – looks materially different to a week ago even if differing schools of thought still prevail. At one end of the spectrum, one school of thought – which we would tend to adhere to – is that that unless PCE-inflation in May surprises materially to the upside, US short-end yields may retrace somewhat and the Dollar give back some its recent gains. At the other end of the spectrum is the view that an in-line (or even slightly below consensus forecast) rise in PCE-inflation in May would be vindication that the Federal Reserve if anything is still “behind the curve” and push short-end rates and the Dollar higher.
Looking to 2013 – The year of the “taper tantrum”
For now we are sticking to “Our core scenario that the Federal Reserve will only start tapering its monthly asset purchases in 2022 and only start hiking its policy rate in 2023” (see Tantrum “lite” won’t help US Dollar, 28th May 2021). We would, however, at this stage turn back the clock, specifically to 2013 – the year of the “taper tantrum”.
At the 19th June 2013 policy meeting, the FOMC member dot-chart was as follows:
- 1 (out of 19) FOMC member thought the Federal Reserve should start hiking rates in 2013.
- 3 members thought the Federal Reserve should start hiking rates in 2014 (by extension 4 out of19 members thought the Federal Reserve should start hiking rates by end-2014).
- 14 members thought the Federal Reserve should start hiking rates in 2015 (by extension 18 out of 19 members thought that the Federal Reserve should start hiking rates by end-2015).
- 1 FOMC member thought the Federal Reserve should start hiking rates in 2016.
The Federal Reserve started to cuts its monthly asset purchases in December 2013 (from $85bn to $75bn) and had cut them to zero by October 2014. However the Federal Reserve only delivered its first 25bp rate hike in December 2015 and waited another 12 months to deliver its second.
Fast forward to the Federal Reserve’s June 2021 meeting and:
- 7 (out of 18) FOMC members think the Federal Reserve should deliver first rate hike in 2022 (so more “hawkish” than in 2013).
- 13 FOMC members think the Federal Reserve should start hiking rates by end-2023 (so less “hawkish” than in 2013).
While the past is no guide to the future, the 2013 timeline gives us comfort in sticking to our broad tapering and hiking scenario. Assuming that the Federal Reserve does not hike rates in 2022, it is conceivable in our view that the 7 FOMC members who currently think it would be appropriate to do so will push for a policy rate hike in early 2023. It would then only take a further 3 members to think the same in order for there to be a majority (10 out of 18) in favour of the Federal Reserve starting to hike rates in early 2023.
The dot-chart is of course anonymous – individual dots are not attributed to members of which only 12 (at most) have voting rights at any one time. However, it is again conceivable in our view that this time round the gap between the start of the taper and the start of the rate hiking cycle will be smaller than the 24 months gap in 2013-2015.
4X Global Research is an independent, London-based consultancy offering institutional and corporate clients focused, actionable, innovative and connected research on Emerging and G20 fixed income and FX markets and economies. For more information please go to www.4xglobalresearch.com