Updated - The Trader: Fed quickfire: Dollar trashed, stocks jump

Updated 7pm

Fed quickfire: Dollar trashed, stocks jump

Stocks jumped to highs of the day before paring gains as they were cheered by what looks on to be a dovish Fed decision – critically it looks as though the Fed is happy to let the economy run really rather hot and won’t intervene. It’s truly remarkable that the Fed can say the economy will rebound by 6.5 per cent this year and not change policy. Even with growth in excess of 3 per cent in 2022 and 2 per cent in 2023; it still sees no need to tighten policy. This reflects what we know already about the Fed’s view on employment and inflation, but it is no less remarkable for it. I would have expected more policymakers to move their dots in a bit, but the median plot did not move into 2023. Doves rule - there is not enough of majority yet seeing any need to act to raise rates. Over to Jay Powell. 

·         No hikes through 2023. 4 from 1 see a hike in 2022, whilst 7 see a hike by 2023 

·         Inflation is seen at or above 2 per cent through 2023, including 2.4 per cent this year, 2 per cent in 2022 and 2.1 per cent in 2023. This is perhaps a little light and if inflation starts to move significantly higher than this it will be a problem and yields could back up further. This is the primary risk now for the Fed as AIT lets inflation expectations become unanchored.

·         Boosts GDP forecast to 6.5 per cent in 2021 from December’s projection of 4.2 per cent, with expansion seen at 3.3 per cent in 2022 and 2.2 per cent in 2023. 

Initial market reaction showed a pop in stock markets – this may get cooled if the market thinks the Fed is losing its grip on inflation by letting the economy run so hot.  The Dollar dropped sharply and has held the losses. Gold broke above $1.740. 10s trade more cautiously around 1.66 per cent, still up over 4bps today.

10.30am Six key questions for the Federal Reserve today

A cautious mood prevails in global stock markets this morning ahead of the Federal Reserve meeting. Stocks are hugging the flatline in early trade, whilst US futures are flat as really nothing matters today except the Fed, its dots and what Jay Powell says in the presser after.  

This is going to be a tough one for the Federal Reserve and its chair as it’s going to be a hard sell to contain yields and inflation expectations. The problem is that the market is already pricing in a big recovery but the Fed is trying to say ‘not yet’, we’ve still got some way to go. This dichotomy exists largely because employment has become the Fed’s go-to measure of monetary policy outcomes, which is new, and not really what markets are looking at (earnings, GDP). Doublespeak is a risky game – the ECB has been tying itself in knots over its communication. Jerome Powell has been much clearer and has been sticking to his guns ahead of this meeting, despite the greatly improved economic outlook, the rapid rollout of vaccines in the US and – crucially – a spike in bond yields. 

Coming into the meeting we note 10-year Treasury inflation-protected securities breakeven inflation rate hit 2.303 per cent, the highest since July 2014. 5-year breakevens are at the highest since 2008.  

Key questions for the Fed today 

 1. Do enough members move their dots to a point where the market sits up and reacts? 

 It seems unlikely that enough members will bring their dots forward to move the median plot much nearer than the first hike of 25bps occurring before the end of 2023, which is still short of the current market positioning which indicates a hike in 2022. An additional 5 members of the total 18 would need to pencil in a hike 2023 to move the median dot. So really this ought not to have much impact on the market – a signal that more than 6 policymakers - say around half or even a majority - are thinking early 2023 would be noteworthy.

2. Is the Fed more likely to lean on long yields or appear happy to let then run higher and then chase with hikes? 

The economic fundamentals and cyclical upswing in growth and inflation suggest the latter – the Fed has been talking more about yields being a function of recovery than worrying about inflation. But it won’t want to signal that it’s really bringing forward hike expectations too rapidly, either. 

3. Does the Fed extend supplementary Leverage Ratio (SLR) relief for banks beyond the March 31st deadline? 

I think it’s unlikely but there may be some action to try and prevent dumping on Treasuries onto the market and the volatility this could generate. I should note that the excellent Zoltan Pozsar of Credit Suisse argues that it won’t be a problem anyway since the vast bulk of Treasuries which are currently exempt from SLR are booked at bank operating subsidiaries, not broker-dealer subsidiaries. “The market assumes that the SLR exemption is what has ‘glued’ the rates market together since 2020, and that the end of exemption means that large US banks will have to sell Treasuries. That view is wrong.” We will find out. 

4. What does transitory really look like in an inflation context - how much above 2 per cent and for how long would warrant action? 

I think on this we will find out more come June when the prints start shooting higher. 

On March 4th, Powell said the Fed would need to see a broader increase across the rate spectrum before considering any action and stressed that the current policy stance is appropriate. He didn’t signal the Fed was in any rush to do anything about rising yields - there was not the slightest hint the Fed was looking to control the yield curve or carry out a twist operation.  The closest hint of concern was this: “We monitor a broad range of financial conditions and we think that we are a long way from our goals,” Powell said, adding: “I would be concerned by disorderly conditions in markets or persistent tightening in financial conditions that threatens the achievement of our goals.” Powell stressed that the Fed is a long way from achieving its goals of full employment and averaging 2 per cent inflation over time. 

5. Does a stronger economic outlook have an impact on Fed decisions?

GDP and inflation expectations have risen since the last dot plot in Dec, and this should be reflected in the forecasts. The OECD raised its growth outlook for the US this year, as have some investment banks.

A much stronger economic outlook is not going to stop the Fed from holding fire for now. Powell has spoken enough times about the ‘real’ unemployment rate being closer to 10 per cent. And the Fed is no longer looking at the inflation dynamics and Philip’s Curve – it's on a mission to right wrongs and get employment back. The Fed will not move on rates and will continue to purchase $80bn of Treasuries and $40bn of mortgage-backed securities each month. Any significant move is unlikely to occur before June, when we might start to see the Fed respond to rising employment levels by voicing a more optimistic economic outlook that warrants a tapering of asset purchases.  

6. Does the Fed signal that inflation will be more than just transitory? 

If not, can it convince us it will be temporary? Inflation remains the elephant in the room – does it materialise in force and how long does that last. Things could get uncomfortable for the Fed from a market perspective over the coming months as base effects lead to a pickup in inflation readings, which will undoubtedly create upwards pressure on yields whatever amount of rationalising about the data. The Fed will want to use this meeting to reiterate that it is happy with this – indeed AIT implies running a hot economy/inflation to counterattacks years of systematic undershooting of its target.  

The other big elephant in the room is issuance – if the Fed really is eyeing a tapering of asset purchases this year (not to be signalled today), then where does that leave long-end yields as Biden – fresh from his $1.9tn Covid relief- swivels his attention to a potential $3tn green/infrastructure bill. How is the market going to absorb all this extra issuance if the Fed is not there to hold the bag? As I suggested yesterday, I think this implies structurally higher bond yields and inflation.