U.S. stocks gave up earlier gains as Treasury yields surged after Fed Chair Jerome Powell signalled the central bank will use its tools to make sure inflation does not become entrenched, paving the way for a March liftoff. Earlier, the stock market may have gotten too pessimistic and priced in too much of a slowdown that was going to come from an aggressive Fed tightening cycle. After hearing Powell talk, it became clear the risk of more rate hikes was elevated and the earlier Wall Street rally fizzled.
The Expected
Coming into the January FOMC policy decision financial markets widely expected the Fed to set up a March liftoff. Powell’s confirmation hearing earlier this month clearly sent a signal that high inflation needs to be addressed and that the economy no longer needs aggressive stimulus.
The Fed held its key interest rate near zero, also noting that QE will end on schedule in March, which paves the way for them to raise rates in March.
What Surprised Markets
Wall Street was divided on what the Fed would say about the balance sheet. The statement outlined the FOMC:
“expects that reducing the size of the Fed’s balance sheet will commence after the process of increasing the target range for the federal funds rate has begun.”
The Fed is showing it will be flexible with the balance sheet, but eventually it will have to choose between fighting inflation or avoiding a deterioration in financial conditions.
The plan going forward
The Fed is going to try to convince markets that it has a plan that is hawkish enough that will fight inflation but not cripple markets and create a de-risking environment. The Fed may raise rates at every other meeting, with the balance sheet runoff starting in May or June. Powell made sure not to make any strong commitments on the course or Fed rate increases or how it will shrink its holdings. The key takeaway is that both mandates are calling for moving away from accommodation. The more Powell talked during the Q/A session, the more hawkish he sounded.
Equities pared gains after Powell didn’t rule out raising rates at every meeting and that the Fed could move sooner, and perhaps faster on the balance sheet than it did last time.
Bank of Canada
The Bank of Canada delivered a hawkish hold as policy-makers will wait until the Omicron wave passes before raising rates. This was a live meeting, and the Canadian dollar tumbled after the announcement but turned positive given the bank signalled a high likelihood it will move in March and that balance sheet normalization will come shortly after. Money markets expect the BoC to raise rates to 1.75% over the next 12 months, which should make the loonie a favorite currency trade for much of the year. Adding to the interest in holding the loonie is the overall consensus that oil prices, Canada’s largest export, should remain elevated for much of the year.
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