Facing both surging inflation and volatile financial markets, the Federal Reserve on Wednesday said it could soon raise interest rates for the first time in more than three years, as they are normalizing their monetary policy.
Key messages were the following:
- A 25 basis points increase is likely coming in March: this was expected and made clear that a 50 basis points is not in the cards;
- FOMC Committee indicated that monthly Quantitative Easing (QE) asset purchases will proceed at just $30bn in February, indicating that the programme will end in March, as expected, i.e the end of QE is NOT happening immediately;
- Quantitative Tightening (QT) will NOT start immediately as “balance sheet shrinking will start AFTER rate-hikes commence”. There was thus nothing new on balance sheet reduction.
The Initial market reaction was rather positive. The Dow rose by 200 points and US 10-year Treasury yield was contained (+2bps).
However, market action turned lower following the conference call held by Fed chair Jerome Powell. The Dow closed down 130 points (-0.4%), which is the market’s worst performance on an FOMC day in at least a year. The US 10-year yield ended up 9 basis points while the US 2-year closed up 12 basis points, which is the biggest jump in 2Y yields since March 2020 as rate-hike expectations rose significantly with a 65% chance of a 5th hike this year being now priced in the market. The yield curve flattened while US 5 year real yield spiked. The dollar rose while gold and bitcoin dropped.
So why was the FOMC statement seen as hawkish by the market?
- Powell’s comment “I think there is plenty of room to raise rates without threatening the labor market” was a sign that the tightening cycle might be more lengthy than expected;
- “Asset prices are somewhat elevated (...) They now pose a threat to financial stability” was seen as clear statement that there is NO FED PUT, i.e the Fed is unlikely to turn less hawkish just because markets are pulling back;
- “The Fed is willing to move sooner (...) and perhaps faster than last time in shrinking the balance sheet” is a hint that quantitative tightening (QT) could end up being stronger and happening sooner than expected. Note that this was counter-balanced by “we want the balance sheet to be declining in a predictable manner (...) by adjusting the reinvestment of maturing debt”.