OK so Wednesday 6pm we will get the latest FOMC decision and market participants will be watching not just for guidance on the tapering decision, but also on the Fed's outlook for inflation going forward - which will be critical to determining the rate hike path once the taper is complete.
It's a big day ahead for Powell
This blog post will aim to guide you through what is no doubt going to be the most important Fed meeting of the year in terms of the policy outlook.
What have the markets been doing in the run up to the meeting?
I know I tend to use these previews the other way around... consider likely policy actions and then look at implications for markets, but in this case I thought there were a few things definitely worth flagging.
The Bond Market:
The first thing to note is the three charts below, which show the various tenors for different parts of the Treasury curve. It's clear that there has been a very rapid increase in 2y Treasury yields. This is likely a reflection of market beliefs that the Fed will now hike more quickly in the face of higher inflation.
Source: Refinitiv
The 10y chart shows that there has been a rise in recent months, but we are still significantly below the YTD highs set back near the start of the year. To me this is showing that the market isn't yet convinced that inflation is here to stay for the longer-term.
Source: Refinitiv
And at the 30y yield we have the opposite phenomenon, where rates have actually been coming down - likely a reflection of longer-term growth concerns. This rate for the 30y to me looks sensible though, since we are talking generally about the longer-term average growth rate which is likely close to 2%.
Source: Refinitiv
Then it's also interesting to compare the yield differentials between certain parts of the curve. As in the chart below, the differential between the 2y and the 10y has been rising since the start of the pandemic, but has now contracted rapidly by almost 50bps in the last month or so.
Source: Refinitiv
So what is this telling us about the market expectations for the Fed?
- The Fed is going to need to hike more quickly in order to keep inflation under control (as evidenced by the 2y yield rising).
- Longer term rates are probably not ever going back to the higher levels seen in the past - 2% might be a terminal value (as indicated by the 30y yield tending down).
These then are the two key things to watch for in both the Fed's statement tomorrow and also in the Q&A with Chair Powell at 18:30 UKT.
What Actually is the Taper?
For the uninitiated, all these phrases like taper etc can be confusing, but to ease that confusion, here's a quick explanation. The Fed has been adding USD120bn per month to the financial system via asset purchases (read: money printing) and the question is when are they going to reduce these purchases.
KEY WORD: Reduce! Not STOP! As long as the Fed continues to make asset purchases it is adding financial accommodation and not taking it away.
What is the expected size of the taper?
This is a more difficult question, I suspect we will get some kind of timeline of when the Fed expects to be done with adding accommodation - likely June/July 2022. This means that we will only start to see interest rate hikes after this point. This is pretty critical for the bond market and interest rate expectations.
It seems likely to me the Fed decides to reduce purchases by 10bn a month for the Asset Backed Securities (ABS - of which it purchases 80bn currently), and 5bn a month for the Mortgage Backed Securities (MBS - of which it purchases 40bn currently).
Of course, you could argue with the housing market on fire that the Fed should taper its mortgages faster than the asset backed securities, but to me this seems more complex than just tapering both so they end within 8 months.
What should we watch for in the statement?
Inflation, inflation, inflation (to quote Madame Lagarde from the ECB last Thursday). There was a very interesting statement from one Fed President Randy Quarles a few weeks ago, where he said "If we are still seeing 4% inflation or in that area next spring, then I think we might have to reassess the speed with which we would be thinking about raising interest rates".
The chart below shows where US inflation currently is... a 13-year high.
Source: Trading Economics
If we do get lots of increasing concern about inflation and the timing of interest rate hikes, expect this to be pretty painful for markets. We'd be sure to see a bit of a sell-off in equities (because the relative return of equities to bonds has declined), and this would likely be a further reason for higher yields in the 2y bonds.
Possible Trades to Make After the Statement:
Basically, if we see hawkishness, then you want to sell stocks, and buy the USD pretty rapidly. The ECB, as we saw Thursday, remains extremely dovish. If the Fed shifts to a more hawkish stance be ready to short EURUSD as quickly as you can - it could be a quick ride down to the 1.13 level.
But what does Luke Young actually expect?
To be honest with you... I think the market has moved too far too fast and the Fed is going to remain highly dovish at this meeting. I would expect Powell to push back against the inflation talk and still chalk it up to transitory factors.
I've had a bit of a look at the main drivers of inflation, and the table below is what I've come up with from the latest inflation report. One thing which pretty quickly becomes clear is that there has been huge inflation in energy prices. This is clearly a transitory factor - these price increases are likely to abate as more production comes online as a response to higher energy prices. Used cars is another good example of where pressures should abate.
Source: Refinitiv
Looking at market expectations for interest rate hikes, it's pretty shocking to me that there are 3 hikes priced for 2022, given the Fed has projected in the dots one hike only.
Sure, the dots haven't generally been a good predictor of anything at all, but I struggle to see a reality where the Fed ends tapering in July and then hikes three times before the end of 2022.
So what will happen to markets?
I think this is tricky to play with equities - the Fed being very dovish could be interpreted as a sign the Fed is happy with higher inflation. If this is the case, then this could actually be bad for equities because of margin pressure etc and higher costs in inputs and labour.
Therefore, it's going to be best to use the USD. If the Fed does come out as quite dovish as I expect, then we would likely see the USD weaken. I wouldn't play this against the EUR, but rather something else with rapidly increasing interest rate expectations... like the AUD.
Note: Last week, the RBA did not intervene in the market to defend its 3y yield target of 10bps. This is clearly a hawkish signal from the central bank and means that rate hikes can begin to be priced in more quickly to the AUD market. I'd expect to see a pretty big leg higher in AUDUSD if the Fed does appear more dovish than expected, and this is the preferred currency I'd look at.
GOLD: Everyone who know me knows I love gold. I think the precious metal might well be the best way to play this trade assuming the Fed isn't too hawkish. It's now a win-win for gold if the Fed is dovish. A) Low rates means the opportunity cost of holding gold is very low, so gold prices will rise. B) Higher inflation generally is correlated to higher gold prices... and dovishness means that more inflation is likely.
Isn't it pretty
Higher gold is a beautiful trade on a dovish signal. I wouldn't be surprised to see gold rocket higher toward the top of recent ranges at USD1830/oz if the FOMC is interpreted as dovish. Beyond that we could even push higher again.
Whatever happens, this Fed meeting is worth a watch and is no doubt the most important of the year. Be careful out there folks... moves will be volatile (particularly in the Powell presso)... so be nimble.
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