‘The beginning of the transition phase’: investors react to a less dovish Fed

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The Federal Reserve has for months been wary of signalling that an end to its pandemic-induced, ultra-loose monetary regime, was in sight: the virus was still lurking, the recovery was too fragile, and uncertainty was rampant.

On Wednesday, the moment when the Fed might start winding down its support rather suddenly appeared on the horizon.

Jay Powell and his fellow US central bank officials embraced a far more optimistic view of America’s rebound — and consequently laid the ground for a turn towards tighter policy.

Not only did the Fed begin talks on eventually reducing the pace of its $120bn per month asset purchase programme, but the economic projections of US central bank officials revealed that most now expect a two-notch interest rate rise in 2023, a year earlier than forecast just three months ago. 

“There’s a pretty sharp shift in the Fed’s approach to managing the recovery here,” said Tim Duy, an economist at SGH Macro Advisors and the University of Oregon. “The weight of the evidence that the economy is rebounding faster than expected, with more inflationary pressures than expected, finally broke through the Fed’s dovish stance.”

During his press conference, Powell sought to explain the changing views among his colleagues. “Many participants are more comfortable that the economic conditions in the committee’s forward guidance will be met somewhat sooner than previously anticipated. And that would be a welcome development.”

Fed officials are, according to the median forecast, projecting that the US economy will grow by 7 per cent this year, and 3.3 per cent in 2022, with the unemployment rate falling to 3.8 per cent by the end of next year, from 5.8 per cent in May. But they are sticking to their view that the economy will not overheat: core inflation will jump to 3 per cent this year, but fall back to 2.1 per cent in 2022 and 2023 — a scenario that the Fed would see consistent with a full recovery. 

The bullish outlook brought cheers from the Biden administration, which described it as evidence that its economic policies, including hefty fiscal stimulus, were working. “It’s validation of an effort to be bold, to be decisive, to act with scale and speed,” one White House official told the Financial Times.

But some investors were unsettled.

“The big picture here is that this is the beginning of the transition phase from really accommodative monetary policy to what is going to be less accommodative monetary policy,” said Michael Collins, senior portfolio manager at PGIM Fixed Income. “We are going to start with tapering and then there are going to be some rate hikes, and I think the market is going to have trouble adjusting to that. It is going to lead to a little more volatility.”

The shift in the Fed’s so-called dot plot of interest rate projections certainly jolted the $21tn government bond market. Treasuries of all maturities sold off sharply following the release, sending yields soaring.

The yield on the benchmark 10-year note rose 0.08 percentage points before paring back some of those losses on Thursday to settle around 1.55 per cent. The five-year note traded about 0.12 percentage points higher at 0.895 per cent and has since regained little ground.

The two-year note yield, which is even more sensitive to the timing of Fed rate rises and had budged little so far this year, jumped as well, to hover at roughly 0.2 per cent. 

The Fed’s indication that two interest rate increases could be in the cards in 2023 was “surprising”, according to Michael Stritch, chief investment officer at BMO Wealth Management, even though some measures of market expectations had already suggested such a shift.

“One would have been enough . . . and two is an exclamation point,” Stritch said, noting that the number of Fed officials pencilling in a move as early as next year was higher now than in March, even if they are still in the minority. 

“This is saying that the timeline has shortened pretty dramatically . . . it is not inconceivable that a 2022 rate hike could be in play.”

Updated fed dot plot gif with Jun 16 meeting

Roberto Perli of Cornerstone Macro was also taken aback, saying the Fed had “blinked”, turning its back on its own vow to only change policy based on clear economic improvements.

“One notch wouldn’t have surprised us too much, but two is indeed a big move for a committee that so far had been adamant about adhering to its new framework and intentionally not wanting to react proactively to changes in forecasts,” Perli wrote in a note. 

During the press conference, Powell tried to stamp out notions of a rapidly accelerating timeline towards monetary tightening, saying the dot plot needed to be taken with a “grain of salt”, there were still risks posed by the virus, and any policy changes would happen step by step. 

The Fed has vowed to continue buying Treasuries and agency mortgage-backed securities at the current pace of $120bn a month until it sees “substantial further progress” towards its goal of a more inclusive recovery. Only later would it increase interest rates, after certain economic milestones were met. 

“The focus of the committee is the current state of the economy, but in terms of our tools, it’s about asset purchases, that’s what we’re thinking about. Lift off [in interest rates] is well into the future,” Powell said. “It’s great to see the progress but, again, I would not declare victory yet.”

The change in stance could help defuse criticism from some economists that the Fed risks being behind the curve in setting policy, something that could mean it later has to slam on the brakes. 

“If the Fed sat here and said there was nothing to see here and we are not worried at all [about inflation], I think their credibility starts to come into question,” said Lisa Hornby, head of US multi sector fixed income at asset manager Schroders.

“We can’t keep living in this world where the Fed has rates at zero and is buying $120bn [government] securities a month and we have a very strong growth outlook.”

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