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Inside the Broker - Federal Reserve takes investors by surprise

Inside the Broker

Federal Reserve takes investors by surprise

The major US stock indices had been grinding higher over the last four weeks or so, with very little intra-day movement. It really felt as if summer had begun a month early. Usually, the summer doldrums begin after US Independence Day in early July, and end two months later after Labor (sic) Day. Market commentators were wondering if investors weren’t being a touch complacent in their attitude to the potential risks of a sharp pull-back, given how all the US indices were trading at, or around, record highs. But it’s fair to say that few had anticipated that last week’s sell-off would be triggered by the US Federal Reserve.

What happened?

The US central bank concluded a two-day monetary policy meeting on Wednesday. As expected, there was no change in the key fed funds interest rate, which continues to trade in a band between zero and 0.25%. Similarly, the Fed’s bond purchase programme will continue at $120 billion per month. But, as expected, the Federal Reserve, and its Chairman Jerome Powell, had to address the surge in inflation that has become apparent over the last couple of months. The first indication of the central bank’s reaction to the inflation jump was from the FOMC’s (Federal Open Market Committee) update to its quarterly Summary of Economic Projections.

Interest rates

The last release, from March, indicated that most committee members felt there would be no increase in interest rates until 2024. But that view has changed, and dramatically. Now the majority expect not one, but two 25 basis point rises in 2023. That would suggest that the Federal Reserve would have to start tapering its bond purchase programme some time ahead of this, perhaps as early as next year. The news saw all the major US stock indices sell off, as did gold and silver while the dollar rallied sharply. Higher US interest rates make the dollar more attractive in relation to other currencies. This in turn should help to dampen inflation, which weakens the case for owning precious metals. Higher interest rates increase the borrowing costs for corporations. But often this is positive for the banking sector as, usually when interest rates rise, banks can make more money as spreads widen between their borrowing and lending rates. Unfortunately, this wasn’t the case last week. Short-term rates rose in response to the prospect of rate hikes coming in the next two years, while longer-term rates fell on the expectation that future economic growth would be dampened by the move. This is the worst possible combination for the banking sector.

Tapering precedes rate hikes

Jerome Powell was later quizzed on inflation during his press conference. He said that if inflation were to prove more persistent than currently forecast, then the central bank wouldn’t hesitate to counter this using all its available tools. But he insisted that bond purchase tapering would come before interest rate hikes, and the Fed would clearly signal when and how it would go about this. But according to the FOMC’s forecasts, Core PCE (the Fed’s preferred inflation measure) is expected to average out at 3% in 2021. As it is already at 3.1% at roughly the year’s halfway point, and is currently trending upwards, it will have to level off and start falling quite rapidly to persuade investors that it can return to 3% this year before heading back to the Fed’s 2% target.


Market reaction

Interestingly, Wednesday’s initial sell-off was partially reversed the following day. But by Friday the sellers were firmly back in control. The S&P experienced its biggest weekly drop since February, while the Dow jones Industrial Average suffered its largest weekly decline since October last year. The catalyst for Friday’s sell-off appears to have been comments from James Bullard, President of the St. Louis Federal Reserve. Mr Bullard was even more hawkish than his colleagues, suggesting that the first 25 basis point rate hike could come as early as next year. Mr Bullard isn’t currently a voting member of the FOMC, although he will be in 2022. But as one analyst pointed out, his is still a minority view when put against the rest of the FOMC, so perhaps it would be best not to overreact. Traders seemed to ignore this advice in early Monday trade, as they drove the S&P 500 back towards support around the 4,130 level. But after hitting an intra-day low of 4,137 the S&P, along with the other US majors, bounced sharply. By Tuesday’s close, the S&P had recouped most of Friday’s losses – quite an impressive daily swing.

Inflation concerns

Inflation looks likely to remain a concern for investors and the Federal Reserve alike. But the latter must also consider the unemployment picture which remains a major issue for the central bank. There is currently a shortfall of around 7 million jobs compared to pre-pandemic levels of employment. The US central bank has repeatedly stated that it wants to see employment back to levels seen in February last year, so this could continue to stay their hand when it comes to pulling the trigger on a rate hike. But they must be careful. When measured by the Consumer Price Index (CPI), headline inflation hit its highest level since September 2008, during the Great Financial Crisis. Core CPI (which excludes food and energy) accelerated at its fastest rate since 1996, the last time that inflation was a serious issue for developed markets. The ‘uneven recovery’ that the Fed keeps reminding us of, may trump inflation fears for now. But if rising prices become persistent and Core PCE continues up to 3.5%, the central bank may have no choice but to act swiftly, rather than more aggressively later. The question now for investors and traders alike is whether the prospect of bond purchase tapering and interest rate rises are now priced into markets, or if we can expect more disruptions in the coming months. Much will depend on upcoming inflation data, combined with the outlook for unemployment.

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