It became clear yesterday that the Fed will likely raise rates in March. As it intends to end bond purchases in “early March” and start quantitative tightening “after the process” of hiking rates has begun, the event can be finally marked as hawkish. Although no details were provided about the path to balance sheet reduction, the announcement offered a series of signals to hit the markets once again. Equities rallied initially as there was no policy change, but they were quick to reverse course. The dollar index rose 0.40% in comparison and continues to ascend, having currently registered a 0.70% gain since. Can this continue for long, and what will it depend on?

It depends on data

Although Chair Powell expressed confidence in economic activity and employment, he acknowledged inflation was “well above” the 2% target and gave weight to “the recent sharp rise” in covid cases. Powell’s hawkish stance indicates that the Committee believes economic conditions are not threatening the market. Confident in the labor market’s ability to “withstand multiple rate hikes,” analysts’ focus will turn to every Non-Farm Payroll report. If unemployment or employment miss expectations due to “new variants of the virus,” resulting to further accommodation, the policy path won’t be appropriate for the Fed to proceed with a more aggressive hiking cycle, and equities could see a bounce until March or more precisely the next NFP.

Aside from covid, another risk to the economic outlook is inflation and the Fed’s intention to continue to hold Treasury securities as part of its easing program and reduce other types of credit instead, such as mortgage-backed securities. That could mean that a runoff could contribute to inflation, making CPI data even more critical. The logical approach is to turn more aggressive when inflation shows persistence, but with holding MBS longer than other types of credit, speculation about the future path to normalization is uncertain, thus worrisome. If any details about its conduct indicate a non-gradual and at the wrong time runoff, the Fed might even have to reverse course.

Wha’a next for the markets?

There were several slight changes in the statement to increase speculation, but the central theme of the meeting was the balance sheet runoff. The market was expecting the Fed to start hiking in March and make comments on how they plan to go from QE to QT. The release of the minutes shed some light to put markets into further action. However, most of the hawkishness seems to have been already priced in.

Despite the uncertainty around the runoff process, Powell reiterated that the Fed Funds remain the primary tool to normalization. This means that with a March hike, the Fed seems to lean towards a more aggressive approach as Powell did little to counter the view of four or more hikes slightly, nor did he vary the idea of a 50bp hike in March. So, with markets now having proved that monetary policy works through expectations, the next step is to price in the March hike, be it with or without details on QT.

Traders started pricing in a 25bp hike in March and are likely to double down their bets on the Fed lifting rates more than four times in 2022. This means dollar up, stocks down. It will be a bumpy road, but if economic data remain “appropriate,” there is no other way investors would want to address the central bank’s new rhetoric. Until the next FOMC meeting, eyes will turn to GDP, NFP, and the usual CPI.

Closing words

Fed’s work on the balance sheet reduction is something new. With economic data in 2022 showing some weakness so far, the Fed might have wanted to kick the first meeting off on positive footing, but the debate around its balance sheet shrinkage will increase speculative bets, thus volatility.

Dependent on a combination of economic and inflation data, policy decisions will certainly keep investors on their toes throughout the year. Right now, the market has been oversensitive to microchip shortages and the technology stocks deleveraging event and earnings reports, and this might change once more when January is out the way.

Amega

Trade with an award-winning broker! Lowest spreads on the market for Forex, Precious Metals, Energies. No re-quotes, no rejection of orders & instant withdrawals.

Open account

www.amega.finance