The Fed against the world | Forexlive
The Fed pushed back with a hawkish 50 bps rate hike yesterday but markets weren’t interested in listening – at least for the most part. In terms of projections, we saw a lower growth forecast and higher rates via the infamous dot plots (as per below). Meanwhile, Fed chair Powell reaffirmed that the tightening cycle will continue and that rate cuts will only be considered “if there is confidence that inflation is moving down to 2%”.
The overall reaction to the key risk event wasn’t straightforward with the initial reaction being the buy the dollar, sell everything else mode before broader market sentiment recovered strongly and then ending up more mixed as a whole with equities lower while Treasury yields ended up falling alongside the dollar as well by the end of the day.
I’d argue that the dot plots remains an important caveat in case markets get it wrong and the Fed gets it right, that is we see interest rates do go above the 5% range next year. Then again, the Fed wasn’t exactly right about how things were going to shape up in 2022 back in December last year, so markets have every right to question policymakers at the helm.
The 2023 dots show a median of 5.1% for the Fed funds rate next year, and that is up from the previous estimate of 4.6%. Therein lies the risk for markets and for the Fed’s credibility – in one way or another.
The central bank has maintained that crushing inflation is their number one objective and while there are signs of cooling price pressures as of late, 7% inflation is still not exactly anywhere near their 2% target. Is that reason enough for the Fed to keep up the pressure in terms of rate hikes?
Meanwhile, market pricing is seeing the terminal rate for this cycle peaking around 4.8%. It’s not so much the figure as it is market participants are angling towards a less aggressive Fed, with a further softening in stance likely expected, and that’s pretty much saying that markets aren’t believing in what the Fed has to say at this point.
Instead, markets seem adamant to make up its own view based on the data and in the last two months, they have been vindicated by a further softening in inflation pressures.
There is a saying in markets that it is best to ‘don’t fight the Fed’. As much as there have been optimistic signs on inflation, that saying could still prove to be the main takeaway in the trading narrative next year. But of course, all of that will depend on inflation data moving forward and that is what markets are betting on.
It is a case of the Fed against the world, with the inflation picture next year going to decide who is right and who is wrong at the end of the day.