Markets have already had to digest a lot of information this year on the two main drivers of asset returns: discount rates and cash flows. Among the issues are increasingly hawkish central banks, led by the US Fed, uncertainty over the outlook for policy and growth generated by Omicron and escalating tensions with Russia over Ukraine.
The question is now whether markets can continue to climb the wall of worries.
In the week ending 21 January, we saw mixed market sentiment manifested in a struggle between the urge to ‘buy-on-the-dip’ and an impulse to sell based on concerns that an aggressive Fed policy would drive up yields. Indeed, the sharp rise in US (real) interest rates has been the number one reason pushing US stock indices lower since the New Year.
Equity markets have shifted abruptly as a result. The S&P 500 index has lost about 10% of its value so far in January, with growth stocks hit particularly hard.
Nothing illustrates the troubled market sentiment better than the huge swing in US stock prices on 24 January with the Dow Jones Industrials index closing up by almost 100 points, or 0.3%, after falling by more than 1 100 points early in that trading session. The tech-heavy NASDAQ Composite closed the day 0.6% higher after initially dropping by almost 5%. This volatility was repeated on 25 January with the Dow recouping most of its 819-point loss to end the day down a modest 68 points.
Catch-up moves could see Fed hike seven times
In the immediate wake of the Fed’s latest policy meeting, stock markets fell sharply across Europe and Asia after Chair Powell signalled the central bank would begin raising rates in two months’ time. Highly valued tech stocks bore the brunt of the selling in Europe and Asia.
Some in the markets now believe the Fed is so far behind the curve that it will raise policy rates by 50bp from March. We do not share that view, but our fixed income team has a strong, out-of-consensus view, expecting seven rate rises this year, whereas the market prices four to five rate increases.
If our more hawkish view gains momentum, a faster pace of Fed rate rises could weigh on market sentiment.
After the recent release of strong US inflation and labour market data (Exhibits 1 and 2), the rate policy-setting FOMC now appears to think the economy is approaching maximum employment and inflation will remain high instead of being transitory.
Chair Powell noted that the ‘economy is in a very different place than it was’ at the onset of the last rate rising cycle: the economy is on a stronger footing, the labour market is healthier and inflation is higher.
This comment was reiterated several times during the press conference and, crucially, with the observation that “these differences are likely to have important implications for the appropriate pace of policy adjustments.”
Indeed, the message from the meeting was significantly more hawkish than the signals in the Fed’s December ‘dot plot’. That showed a clear consensus across the FOMC on raising rates three times this year.
When asked about the possibility of raising rates in 50bp increments, Chair Powell said no decisions had been made. That was not an endorsement of the idea of a 50bp hike, but neither was it a denial.
Taking away the punch bowl
The FOMC confirmed that the Fed would shrink its massive balance sheet significantly by ending the reinvestment of maturing securities – assets which it bought in large volumes during the pandemic to support the US economy – after it has begun raising rates.
Chair Powell signalled that the balance sheet run-off might begin at the May or June FOMC meeting. Some market participants expect the Fed to act more aggressively by cutting its existing asset purchases by USD 60 billion a month or more.
According to Statista 2022, the size of the Fed’s balance sheet was USD 8.87 trillion on 18 January. Even if the Fed ran down its holdings by USD 100 billion a month, its balance sheet would still be larger by the end of 2024 than it was in January 2020 (USD 4.17 trillion) when the pandemic started.
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