Double taper & three rate hikes in 2022
Powell delivered one of the most hawkish monetary policy decisions in recent history on Wednesday. The Federal Reserve will speed up its bond-buying tapering timeline in response to the highest inflation levels in decades. The pandemic that led the US central bank to purchase $120 billion a month is ending in three months, as policymakers decided to cut asset purchases by double the amount previously announced and positions the central to raise interest rates earlier than previously estimated. According to the new dot plot, interest rates will be lifted three times in 2022, and by another three in 2023.
We are now clearly heading into the early stages of the tightening cycle. In theory, tightening monetary policy is bad for risk assets, especially given the stretched valuations in growth stocks. However, the market’s reaction was surprising yesterday, with stocks surging and the dollar declining post the announcement and as Powell began his press conference. Many investors are possibly questioning such a reaction.
Looking at recent history, the markets responded differently to tightening cycles. Out of the four tightening cycles over the past 30 years, only one led to markets declines at the initial tightening phase, while the rest occurred towards the end of the tightening cycles. So, tightening monetary policy by itself is not sufficient to determine the direction of equities over the short and medium-term.
Markets were already anticipating a hawkish tilt and were not taken by a surprise. Powell has also managed to convince investors that inflation is not out of control, and he will bring it back to target without slowing the economy or driving unemployment higher. Neither the Federal Reserves nor the markets believe that inflation will remain high over the longer run, and that’s evident in the bond markets where US 10-year yields are hovering near 1.45%. If the economy doesn’t experience a new external shock, equities should continue to outperform bonds, and that’s where investors need to be.
The dollar should continue to benefit from the diverging monetary policies, and the overnight declines in DXY are likely to be proved temporary. Therefore, I continue to favor the dollar against the euro and the Japanese Yen until at least the end of Q1 2022.