FOMC and The Beginning Of The End?

The Federal Reserve hiked interest rates by 25 basis points (bps) yesterday to 4.75% (upper bound), stating that, it “anticipates that ongoing increases in the target range will be appropriate”.

Earlier the Fed suggested that three months of continued disinflation (reduction in inflation, not to be confused with deflation which is a drop in prices) would be a sign of progress, allowing them to think about downshifting the pace of hikes and potentially pausing.

Later, one of the Fed’s most closely watched hawks, Governor Christopher Waller suggested that “From the risk management side — I need six months of data, not just three.”

Looking at the data, the core personal consumption expenditures index rose 2.2% in the three months through December on an annualized basis, and 3.7% over the past six months, a slowdown from its 4.4% pace in the last 12 months.

With the current rate hike, the real policy rate has finally turned positive as the target rate range is above core inflation for the first time since 2019.

Thus, if the Fed is data dependent, as Chair Powell alluded to yesterday when asked about the rate cuts being priced in by the market in the second half of 2023, then it does not fit well with an 85% chance of a rate hike in March (data as per CME FedWatch tool).

While there a possibility of a hike next time, the 85% chance pricing seems quite high.

Chair Powell broadly stuck to his comments from the previous meeting i.e. the Fed needs to see core-services ex-shelter inflation come down and that they need to avoid any pre-mature loosening (rate-cuts).  However, Chair Powell adds that they have finally begun to see the process of disinflation begin and that they welcome it.

The surprising fact was that Chair Powell didn’t provide any significant pushback to the recent loosening of financial conditions which has taken place on the back of an everything rally over the past three months, from government bonds to credit to equities.

This was the final nail in the coffin for US dollar longs. The US dollar index (DXY) tanked 0.9% and was last trading sub-101 levels while the Euro hit a fresh 10-month high of $1.1000 ahead of an ECB meeting, where the quantum of rate hikes priced for 2023 is much higher than the Fed.

While it is prudent to observe and confirm the price action that takes place on volatile central bank meeting days, we did see US 10-year yields drop by 9 bps to 3.42%, the lower end of the 2-month range, while US 2-year yields went from +5 bps to -9 bps on the day to settle at 4.11%.

The rate cut pricing for H2 2023 remained close to 50 bps, according to the Fed Fund futures market. Now we look ahead to the Bank of England and European Central Bank meetings today.

From the desk of 

Devina Mehra                                                               

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