Last week’s FOMC meeting raised rates and set the stage for a rapid succession of hikes.
Powell repeated this message on Monday and paved the way for a 50bps hike in May, with potentially another 50bps in June.
The situation is similar to the 1980s, and as ING point out “the dollar went through the roof during this period.”
Markets are showing further stability on Tuesday’s session after a slow but ultimately bullish Monday. Ukraine news still dominates but is having little effect on risk appetite as stock markets grind higher and in some cases are higher than they were when Russia invaded on the 24th February. The FTSE and Dax are higher by +0.5% and +0.75% respectively, following on from strong Asian trading.
Currencies are reflecting an improved risk-on environment, but the Euro remains relatively weak and the US dollar is back in rally mode after last week’s shallow dip. This is now less related to Ukraine – at least the initial panic of war – and more due to the trajectory of central banks. On one hand the ECB will find it difficult to tighten at anything more than a snail’s pace, while the Fed have already hiked once and continue to signal full speed ahead. This was again evident in Fed Chair Powell’s speech on Monday which sent a very hawkish message.
Powell Gets Tough on Inflation
Inflation has shifted from, as the Fed used to term it, ‘transitory’, to a menace that is threatening to get out of control. Sky high oil prices are one driver, but just about everything is rising in price, and quickly. This is becoming not only an economic problem, but a political one and Biden faces a tough test in the mid-term elections later this year. The Fed seem to finally recognize the seriousness of the problem and are going on a full-on attack with the most effective policy they have at their disposal – rate hikes. Last week’s FOMC meeting not only raised rates for the first time since the pandemic but saw a very hawkish jump in the dot-plot projections.
“The median dot rose more than expected to show seven hikes total in 2022, three and a half more in 2023, and a terminal rate of 2.75% that is clearly above its median neutral rate estimate of 2.375%,” write Golman Sachs in its review.
A potential 10 hikes in quick succession will have consequences. The cost of financing debt will sky-rocket and the economy is bound to slow. Powell said that the risk of recession was “not particularly elevated” in last week’s meeting but the markets seem to think otherwise. One of the most reliable indicators of a recession, the 10y-2y yield curve is flattening and a number of curves are already inverted (i.e. went below 0%). Indeed, the 10y-5y inverted on Monday and the all-important 10y-2y could be next. As ING explain:
“Hawkish comments from Fed Chair Jerome Powell yesterday have injected another wave of re-pricing into US rates markets. US 10 year yields are up 18bp to 2.33%, but the short-end has sold off more and the US 2-10 year curve has now narrowed down to 15bp. Expect much speculation over whether a flat or inverted US yield curve means recession – and certainly, this energy shock has increased the chances of a late 2023/24 US recession.”
Perhaps a mild recession is the only way to slow inflation. Demand remains very high and the US economy is growing strongly despite ethe rising costs. Clearly the Fed thinks the economy is robust enough to weather the hikes. However, with so much debt in circulation, the knock-on effects could be significant. One of these effects will be a surge in the US dollar and this could easily push EURUSD below 1.07 and even the 2020 lows. ING compare the current situation with the 1980s and point out “the dollar went through the roof during this period.”