The highest inflation in 39 years, volatile equity markets, a flattening bond yield curve, and a spreading new Covid-19 variant have all hit the markets in the last two weeks. And the question on every investor’s and trader’s mind is what is the US Federal Reserve going to do about it?
The November FOMC meeting saw Fed officials make the first call on tapering their bond purchases in their quantitative easing program. The plan was to reduce asset purchases by $15 billion a month and continue at this pace until the entire $120 billion a month bond-buying program ends in May 2022. Meanwhile economists were still seeing more price spikes due to transitory pressures with consumer prices hovering near 7%. More recently, Chair Powell had finally admitted that inflation is more than a passing side effect of the pandemic, suggesting that the debate over “transitory” price rises is over.
Many believe the Fed might already be behind the curve when it comes to controlling inflation and needs to act fast to prevent severe future shocks to the economy. Given the statements we have heard from several officials, including Powell himself, expect the Fed to announce an acceleration of tapering by $30 billion a month, starting in January 2022 so that the program ends by March, allowing the Fed to begin rate hikes earlier than previously anticipated.
While US consumer confidence remains near a decade low, spending on debit and credit cards has surged significantly. Bank of America saw spending increase 20% compared with last year and 28% compared with November 2019. So, Americans are saying one thing while behaving in a totally different manner, indicating that the economic recovery remains robust.
The Fed will likely acknowledge that economic activity remains strong, labor markets have improved further, and financial conditions are still accommodative. This would further encourage a faster ending of emergency measures. It will be interesting to see if the statement keeps the line “longer-term inflation expectations remain well anchored at 2%.”
Most of the expected amendments by the Fed are already priced into markets, but how the bank will respond to the Omicron variant remains unclear. The September FOMC dot plot showed expectations for a one rate hike in 2022, followed by three in 2023 and another three by 2024. These dots are now expected to shift upwards with at least two rate hikes occurring in 2022.
The pace of interest rate hikes is now concerning bond investors with the spread between 30-year and 2-year Treasury yields the flattest since March 2020. Bond markets are signaling that economic growth will be heavily impacted by a faster rate hike cycle, but stock markets do not seem to agree with the S&P 500 hovering near its record highs. So, the Fed has a tough job to address both bond and stock investors’ concerns.
The dollar is likely to remain elevated against a basket of currencies, especially against low yielding currencies. Given the divergence in monetary policies, expect to see new yearly lows for the euro and yen. Traders will be watching to see if EURUSD breaks below 1.10 and USDJPY moves above 115 before year end.