Apparently, no one expected
The Fed, when they last met, detected
Their actions thus far
Were somewhat bizarre
And so, a new stance was erected
Not only would they halt QE
But also, a shrinkage they see
In balance sheet sizing
So, it’s not surprising
The bond market filled bears with glee
“…it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
“… participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience.”
“Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”
These were the words from the FOMC Minutes of the December meeting that roiled markets yesterday afternoon. Arguably there were more as well, but these give the gist of the issue. Suddenly, the Fed sounds so much more serious about their willingness to not only taper QE quickly, and not only begin to raise the Fed Funds rate, but also to actually shrink their balance sheet. If the Fed does follow through on this, and finishes QE by March, starts raising the Fed Funds rate and also begins to reduce the size of the balance sheet, then you can expect that the global risk appetite is going to be pretty significantly reduced. In fact, I would contend it is the last of these steps that is going to undermine risk assets, as balance sheet reduction will likely result in higher long-term bond yields and less liquidity available to flow into risky assets. As I have highlighted in the past, in 2018, the last time the Fed was both raising interest rates and shrinking the balance sheet, the resulting 20% equity market decline proved too much to withstand. Are they made of sterner stuff this time?
One other thing to note was that while omicron was mentioned in the Minutes, it was clearly not seen as a major impediment to economic growth in the economy. The fact that, at least in the US, there doesn’t appear to be any appetite/willingness for complete lockdowns implies that the nation is beginning to move beyond the pandemic fear to a more relaxed attitude on the issue. Granted there are still several city and state governments that are unwilling to live and let live, but for the nation writ large, that does not seem to be the case. From an economic perspective, this means less demand interruptions but also, likely, less supply interruptions. The inflationary impact on this change in attitude remains uncertain, but the underlying inflationary trends remain quite strong, especially housing. Do not be surprised to see CPI and PCE peak in Q1, but also do not be looking for a return to 2.0% levels anytime soon, that is just not in the cards.
And really, that was the driving force in yesterday’s market activity and is likely to be the key feature going forward for a while. We will certainly need to pay close attention to Fed comments to try to gauge just how quickly these changes will be coming, and we will need to pay attention to the data to insure that nothing has changed in the collective view of a strong employment situation, but in the US, at least, this is the story.
The question now is how did other markets respond to the Minutes and what might we expect there? Looking at equities, the picture was not pretty. Following the release, US equity markets sold off sharply with the NASDAQ falling 3.3% on the day and both the Dow (-1.1%) and S&P500 (-1.9%) also suffering. Activity in Asia was also broadly weaker with the Nikkei (-2.9%) and Australia’s ASX (-2.75%) both sharply lower although Chinese stocks were less impacted (Hang Seng +0.7%, Shanghai -0.25%). The story there continues to revolve around the property sector and tech crackdowns, but recall, both of those markets had been massively underperforming prior to this Fed news. As to Europe this morning, red is the color of the day (DAX -1.0%, CAC -1.2%, FTSE 100 -0.5%) as the data mix showed continued high inflation in Germany with every Lander having reported thus far printing above 5.1%. As to US futures, they are not buying the bounce just yet in the NASDAQ (-0.5%), but the other two indices are faring a bit better, essentially unchanged on the day.
It can be no surprise that the bond market is under further pressure this morning as the Fed has clearly indicated they are biased to not only stop new purchases but allow old ones to mature and not be replaced. (There is no indication they are considering actually selling bonds from the portfolio. That would be truly groundbreaking!) At any rate, after the Minutes, yields jumped an additional 3bps and have risen another 2.8bps this morning. This takes the move in 10-year yields to 23 basis points since the beginning of the week/year. Technically, we are pushing very significant resistance levels in yields as these were the highs from last March. If we do break higher, there is some room to run. As well, the rise in Treasury yields is driving markets worldwide with European sovereigns all selling off (Bunds +3.5bps, OATs +4.2bps, Gilts +5.5bps) and similar price action in Asia, where even JGB’s (+2.0bps) saw yields rise. Real yields have risen here, although as we have not seen an inflation print in the US since last month, that is subject to change soon.
On the commodity front, the picture is mixed today with oil (+1.2%) higher while NatGas (-1.2%) continues to slide on milder weather. Uranium (+3.9%) has responded to the fact that Kazakhastan is the largest producer and given the growing unrest in the country, concerns have grown about its ability to deliver on contracts. With yields higher, gold (-0.6%) and silver (-2.2%) are both softer as are copper (-1.4%) and aluminum (-0.5%). Clearly there are growing concerns that higher interest rates are going to undermine economic growth.
Finally, in the FX markets, the broader risk-off tone is manifesting itself as a generally stronger dollar (AUD -0.7%, NZD -0.6%, NOK -0.35%) with only the yen (+0.25%) showing strength in the G10. In the EMG bloc, the picture is a bit more mixed with laggards (THB -0.9%, CLP -0.7%, MYR -0.5%) and some gainers (ZAR +0.8%, RUB +0.7%, HUF +0.5%). Rand is the confusing one here as the ruble is clearly benefitting from oil’s rise and the forint from bets on even more aggressive monetary policy. However, I can find no clear rationale for the rand’s strength though I will keep looking. On the downside, THB is suffering from an increase in the lockdown levels while MYR appears to be entirely dollar driven (higher US rates driving dollar demand) while the peso seems to be suffering from concerns over fiscal changes regarding the pension system.
On the data front, this morning brings Initial Claims (exp 195K), Continuing Claims (1680K) and the Trade Balance (-$81.0B) at 8:30 then ISM Services (67.0) and Factory Orders (1.5%, 1.1% ex transport) at 10:00. But tomorrow’s payroll report is likely to have far more impact. And the Fed calendar starts to fill out again with Daly and Bullard both on the slate for today and seven more speakers over the next week plus the Brainerd vice-chair hearings.
I’m a bit surprised the dollar isn’t stronger in the wake of the new Fed attitude, but perhaps that is a testimony to the fact there are many who still don’t believe they will follow through. However, for now, I expect the dollar will continue to benefit from this thesis, albeit more gradually than previously believed, but if we do see risk appetite diminish sharply, look for a little less tightening enthusiasm from Mr Powell and friends, and that will change sentiment again.
Good luck and stay safe