The Federal Reserve’s hawkish tweaks to its dovish outlook - the central bank sees inflation increases above its 2% target this year being only temporary - have raised fears the Fed will drop its new average inflation targeting strategy. The Fed’s move to start discussing when to taper its quantitative easing and its new median forecasts implying two interest rate rises in 2023 have caused financial markets to price in a full 25bps hike in the fed funds rate in 2022.
Source: Bank of Singapore, Bloomberg
The Fed’s tweaks have thus undermined reflation trades. Risk assets fell with the S&P down more than 1% on Friday. The Treasury curve also flattened as the first chart shows with short-term 2Y yields reaching their highest levels since April 2020 at 0.25% while long-term 10Y and 30Y yields fell to 1.43% and 2.01% respectively.
Source: Bank of Singapore, Bloomberg
Inflation expectations were hit too. The chart above shows 10Y breakeven rates have fallen from 2.60% in May to 2.24% now. Similarly, gold has weakened this month from USD1,900 an ounce to USD1,765 while the USD rose sharply causing the EUR to slide from 1.21 to below 1.19.
We had expected the Fed to start discussing tapering at last week’s meeting and to upgrade its interest rate forecasts. But the central bank’s tweaks clearly surprised the markets. Thus, in the near-term investors may keep unwinding reflation trades, squeezing the USD higher still.
The Fed, however, is unlikely to abandon average inflation targeting and start raising interest rates as early as next year. Officials forecast core inflation will peak around 3% this year and then return towards their 2% target in 2022 and 2023. Thus, financial market pricing of rate hikes in 2022 appears premature. Moreover, Chairman Powell downplayed the new interest rate forecasts or ‘dots’ warning ‘the dots are not a great forecaster of future rate moves.’
Instead, the Fed is determined to avoid another taper tantrum. Here, lower inflation expectations give the central bank the leeway to maintain its quantitative easing this year to boost the labour market’s recovery. Thus, the Fed is still likely to only begin slowing its bond buying in early 2022. We expect the Fed will keep stressing its exit from ultra-loose monetary policy will be only gradual, helping sentiment recover over the summer.Disclaimer applicable to recommendation
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