Sat, May 08, 2021 @ 23:16 GMT

Fed Decides

The Federal Reserve (Fed) will give its latest policy verdict today, and there should be no surprise for Fed watchers at today’s announcement. The Fed should keep interest rates near zero and its massive bond purchases unchanged. The dot plot will certainly not reveal a meaningful change either.

Both at his semiannual testimony before the congress and the week following his testimony at a Wall Street Journal Event, the Fed Chair Jerome Powell seemed very detached and relaxed faced with the fast-rising inflation expectations that pressure the sovereign yields persistently higher since the beginning of the year. To him, the major catalyzer behind the move is improved economic outlook and not necessarily the rising inflation expectations.

And the inflation data gave no sign of an abnormal, or an unexpected overheating in consumer prices last week. On the contrary, the core inflation even unexpectedly eased. Also, released yesterday, the US retail sales plunged 3% in February following a 5.3% jump a month earlier due to the stimulus checks.

As such, meandering retail sales combined to tame inflation will at least give some credibility to Jerome Powell that the surging inflation expectations won’t materialize as strongly and durably as investors fear – so the Fed could maintain its ultra-supportive policy stance without risking an abnormal overheating in the US economy.

But in the medium-term, we know that the only possible direction for the yields is up, and the most probable market response to higher funding costs is more reflation trade, the continuation of the migration from growth to value stocks, cyclical stocks such as bank, energy and commodity stocks.

One piece of news that could temper the rising inflation expectations is Joe Biden’s plans to raise taxes. According to the latest news, Biden is preparing the biggest tax hike since 1993, as the massive Covid aid packages need to be financed at some point. The tax hike would hurt both companies and rich individuals. So, there are two issues that stock investors will be facing shortly:

1. The rising funding costs as yields and real rates move higher.

2. Higher corporate taxes that would eat into revenues.

So, the only hope for stock investors is that the Fed doesn’t tighten its monetary policy too soon.

Also, investors are now prepared to stomach a further rise to the 2% level in the US 10-year yield in the coming months. Therefore, it’s not necessarily where the yields are, but how fast they rise that matter for the overall risk appetite.

Another collateral damage of the reflation trade is gold. Investors have been ditching their long speculative positions in gold as a result of higher sovereign yields, hence higher opportunity cost of holding the non-interest-bearing gold. The combination of steady rise in sovereign yields, and softening inflation expectations should continue weighing on gold prices and pave the way for a further downside correction which could pull the price of an ounce as low as $1500, last seen a year ago. Therefore, top-sellers are certainly around the corner and will cap the gold’s upside potential near the $1750 per oz in the short-run. Given how well investors are rewarded across all asset classes these days, the rising inflation fears hardly stand up against solid return potential elsewhere.


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