Fed Gets Serious About Inflation
Equity markets are proving to be remarkably resilient in the face of a significant increase in hawkish rhetoric from Fed Chairman Powell – both yesterday and in recent days – and a major sell-off in Treasury bonds.
My assumption about the latter is the markets have for now pivoted their main focus away from the Russian war with Ukraine to the inflation threat at home (made worse, of course, by the war itself). Prior to the war, US 10-year yields peaked at 2.07% in mid-February (before the war began); then a safe-haven move into Treasuries saw the yield drop to just below 1.7% in early-March; today the yield is at 2.38%, a rise of close to 70bp in just two weeks. Above all, this signals how the Fed’s rhetoric has turned much more hawkish, as well as heightened inflation expectations short-term.
I see the following as the key comments from Chairman Powell’s remarks to the National Association of Business Economists yesterday:
- The Fed is willing to move to a faster pace of rate increases and push rates to ‘relatively high levels’ in its quest to cool off inflation. This means to me a significant risk of a 50bp rise in rates at the next FOMC meeting (in May) as well as the possibility that the FOMC eventually moves the funds rate above its neutral rate (seen as around 2.4%);
- Fed funds are likely to be around 2% by year-end in my view;
- Powell said ‘nothing’ would stop them moving by 50bp at the next meeting;
- The Fed had expected (as I did) that annual inflation would peak in Q1 and then fall slowly. Powell said this story ‘had fallen apart’ – that is a dramatic statement from any Fed Chairman;
- The Fed may announce the start of its balance sheet reduction program (quantitative tightening) as early as the next FOMC in May;
- Very importantly, Powell said that, measured correctly (in his view), the yield curve is not ‘forecasting’ recession. The market likes to focus on the 2/10-year spread (currently at around 20bp only). My own preferred measure is 3 months/10 years, which currently stands at around 190bp. Powell himself – as quoted by Bloomberg – said that the best measure of the curve is the current three-month rate versus where the market expects that rate to be in 18 months’ time; that ‘curve’ is very steep;
- In short, the bond market and the yield curve are not predicting recession. And, therefore, are no constraints on the Fed raising rates a lot further – and quickly.
Meanwhile, equity markets are rallying.
They are probably happy the Fed is determined to stamp out inflation. At the time of writing, MSCI EM is down ‘only’ 8.3% ytd and is up over 7% from its low just a week ago. As of last night, EM ex-China was down 6.2% in 2022 versus DM ex-US being down 6.4%.
Written by Geoffrey Dennis
Geoffrey is an Independent Emerging Markets Commentator & the Former Head of UBS Global Emerging Markets Strategy
2021: Reviewing a ‘Contrarian’ Year for Emerging Markets
Great Depression & The Federal Reserve
Back To News
Fed Gets Serious About Inflation
