The Fed has capitulated.
The two-day meeting of the Federal Reserve Bank that took place last week offered a plethora of surprises. For more than a year since the pandemic’s onset, investors had almost started believing Chair Powell and the FOMC (Federal Open Market Committee) members about inflation being transitory. Those investors were caught by surprise when Powell was forced to admit that ‘inflation could run hotter than the central bank expected’. Those updated expectations were followed through to the so-called ‘dot-plot,’ which gives an indication as to when the Fed officials see the interest rate hikes happening. Generally speaking, interest rate hikes are raised in conjunction with the economic recovery, particularly taking into consideration price stability, i.e. inflation, as well as the health of the labor market and unemployment rate. Dot-plot signals now that there could be two interest rate hikes in 2023, whilst previous projection did not see any hikes until beyond 2023.
Another Taper Tantrum?
The other major Fed monetary policy tool, asset purchases from the open market, was also highlighted by the Chairman as potentially being curtailed in the future. Open market asset purchases became a norm after the 2008 financial crisis when the Fed decided to intervene by purchasing the risk-free U.S. Treasury issued debt, which in turn helps to increase liquidity in the financial markets. It should be noted that the Fed and the federal Treasury are two independent institutions; the former has no obligation to purchase debt that the latter issues, whilst the latter is responsible for financing the U.S. budget and clearly has an interest in ensuring there are enough buyers.
Winding-down the asset purchases program after the 2008 crisis was quite a spectacle when back in 2013 the markets reacted violently to the comments of former Chair Ben Bernanke about tapering. The so-called ‘taper tantrum’ caused a sell-off in the credit markets and yields to spike, while equities shed around 7 percentage points. The logic behind such a market move is that once the Fed stops buying the assets, there will be less buyers by natural extension and, therefore, the prices are going to plummet. The price of debt is inversely correlated to the yield, which effectively is the return an investor receives, the lower the price, the higher the return or yield. Once investors realized the Fed was planning to taper purchases, they started selling their positions, causing the ripple effect that echoed across financial markets.
U.S. dollar leads the way
We saw a similar reaction last week when the combination of dot-plot and comments about tapering signaled that the Fed believes conditions are good enough to stop the liquidity support the markets have become addicted to. The U.S. Treasury 10-year yield touched 1.59% intraday, the dollar jumped almost one percentage point, and the S&P 500 index shed half a percentage point. The so-called Fear Index, or VIX, was up as well, and has remained elevated since. The dollar has also remained at higher levels with DXY trading near $92.0 levels. This week is likely to show whether investors remain cautious or continue piling on to the reflation trade that has been in vogue since early this year. A stronger dollar will put pressure on the markets but offer plenty of trading opportunities with the ensuing volatility spikes.
The S&P 500 slid -1.91% to 4224.80 points, while the tech-heavy Nasdaq-100 rose 0.37% to an all-time high of 14,049.58 points. Russell 2000, representing the so-called value or reflation trade we have been writing about, shed -4.20%. The dollar, measured by the DXY index, had its best week since March and rose 2 percentage points. Interest rate sensitive (or real interest rate sensitive) gold pierced all support levels and closed the week down 6%. Oil remained resilient, gaining 62 basis points, and closed at a swing high of $71.41.
Have a great trading week ahead!