Overnight, Federal Reserve Chairman Powell was dovish when he testified to Congress, helping push the S&P above 4,370, gold prices up to USD1,825, 10Y Treasury yields below 1.35% and the USD weaker with the EUR rising above 1.18.
First, the Fed Chair made it clear officials want to see America’s recovery make ‘further substantial progress’ before the central bank starts tapering quantitative easing from its current pace of USD120 billion a month of bond buying: ‘at our June meeting, the committee discussed the economy’s progress toward our goals since we adopted our asset purchase guidance last December. While reaching the standard of ‘substantial further progress’ is still a ways off, participants expect that progress will continue.’
Second, Powell also signaled the Fed would tolerate another six months of inflation running above its 2% target before officials decide if rising prices require tighter monetary conditions: ‘inflation has increased notably and will likely remain elevated in coming months before moderating. Inflation is being temporarily boosted by base effects, as the sharp pandemic-related price declines from last spring drop out of the 12-month calculation. Prices for services that were hard hit by the pandemic have also jumped in recent months as demand for these services has surged with the reopening of the economy. The question will be, where does this leave us in six months or so when inflation as we expect does move down.’
Source: Bank of Singapore, Bloomberg
Thus, despite June’s consumer price index (CPI) report this week coming out stronger-than-expected for the fourth month in a row - core prices excluding volatile food and energy costs surged by 0.9%MoM to record its highest inflation rate since 1991 at 4.5%YoY - the Fed Chair was clear that increases in consumer prices as the US economy reopens are still likely to be only transitory. The central bank will therefore be willing to wait until the end of the year to see if its dovish stance will turn out to be justified.
We expect the Fed will keep supporting risk assets this year. Over the next few months, officials will want to see how inflation evolves, whether the delta variant spreads further and if the labour market continues to recover. We thus see the Fed still being slow to taper quantitative easing, discussing the timing at its next few meetings but only announcing in December that its bond buying will start to be reduced from January.
The Fed’s gradual approach to tapering is supporting risk assets and stopping a broader rally in the USD by keeping US real yields - Treasury yields adjusted for expected inflation - firmly in negative territory as the chart above shows. After Powell spoke, 10Y real yields fell back towards -1.00%, a historically very low level. By continuing quantitative easing at its current pace for the rest of 2021, the Fed will keep US yields low to the benefit of risk assets. We see the benchmark 10Y Treasury yield only rising to 1.75% by the end of 2021 and 1.90% over the next 12 months.
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