Fed signals retreat from pandemic crisis measures
The dollar has its best day in more than a year, US Treasury yields surged, and stocks slipped from their record highs posted earlier this week. Thanks to the Federal Reserve that decided to step out from its comfort zone.
The Fed found yesterday the right opportunity to change tone. The financial markets environment and financial conditions were good enough to send a new message. We had bond yields deeply in negative territory, junk bonds yielding less than inflation, stocks at record highs, and a booming economy. Still, many were surprised by the Fed’s new projections.
The US central bank, as expected, kept interest rate on hold at the range of 0 – 0.25% and maintained its asset purchase program at $120 bn per month. But compared to March meeting when most Fed officials expected interest rates will remain near zero until 2024, the consensus now has shifted towards a 2023 lift-off. More interestingly, the dot plot revealed not just one interest rate hike projected in 2023, but two. That took many traders by surprise, and hence we saw this spike in yields and dollar strength.
Fed Chair, Jerome Powell sounded more optimistic than previous press conferences. The one aspect which refrained him from signaling any tightening in monetary policy during past meetings has been jobs. Now he thinks that the labour market is improving, anticipating low unemployment, and rising wages. Powell continued to claim that inflationary pressures are transitory, but he now sees the risk of inflation running higher than predicted. Fed officials revised inflation expectations sharply higher for 2021. They anticipate PCE inflation to hit 3.4% this year, up 1% from March projections, and inflation rate to hold above 2% for 2022 and 2023.
Yesterday’s monetary policy decision may not just be a one-day event for the market. Especially for the US dollar where a key factor for its weakness was a stubbornly dovish Fed. Financial markets will now perceive economic data in a different way. Higher than anticipated inflation figures will now translate into higher bond yields and a higher dollar. Same goes for jobs and other tier one data.
Powell did not hesitate to say the FOMC had “talked about talking about tapering”. It is the first step towards withdrawal of aid. Of course, this would not happen immediately but expect it within the next six months. The economy may need to depend less on the generous Federal Reserve going forward. This is going to be a tricky environment for investors as markets likely to become more volatile going forward.