Markets turn USD positive and risk negative post FOMC

A hawkish-sounding Fed chair Powell has driven a key reaction in bond markets. With yields higher this is Treasury yields moving higher, there is a reverberation across forex, commodities, and indices. This has the potential to run in the coming weeks.

• Highlights from the Fed meeting include a likely March hike, the potential for faster rate increases, and the start of balance sheet reduction in the coming months
• Reaction on bond markets shows how forex, indices, and commodities will be impacted.
• The price implications for major markets 

Fed meeting highlights

The FOMC statement was not all that hawkish. Markets did not react too much initially.

• The Fed funds rate (interest rate) stays the same at a range of 0.0% to 0.25% - as expected
• The existing run down of asset purchases continues, to end in early March – as was previously guided

There were a few changes to the FOMC statement, although there was nothing too significant:

• The removal of the section at the top talking about using the “full range of tools to support the economy – this is understandable if they are getting ready to raise rates.
• The committee expects that it will soon be appropriate to raise the target range. This is a thinly veiled way of saying that rates are going up in March, the next meeting
• The decision was unanimous

Here are the statement changes (courtesy of Zerohedge).

There was also a document uploaded to the Fed’s website, laying out the principles of balance sheet reduction. Once more, there was nothing overly surprising here. 

There were a few takeaways from this:

• It was interesting to see the Fed underscoring the use of interest rates (and not balance sheet reduction) for monetary policy tightening. This suggests a gradual rundown of the assets on the balance sheet, which is currently around $9 trillion in size. 
• There was though just a hint on timing, being after rate hikes have begun. This will firm up speculation that it will begin in the summer (perhaps announced at the June meeting). 
• Also the reduction will be in a predictable manner.

All these are fairly benign with regards to monetary policy tightening. 

Powell’s hawkish press conference

The more considerable market reaction has come in response to the press conference. Here, there were a couple of hawkish factors:

• Fed Chair Powell did not rule out the prospect of raising rates at every meeting. 
• He also said that there had not been a discussion on whether there would be rate rises at a speed of 50 basis points (so again not ruling this one out).

It was these comments that saw markets sit up and take notice. According to interest rate futures, market participants are now pricing for at least four rate hikes in 2022.  

This is similar to CME Group FedWatch which suggests that the probability of having a fourth rate hike by December is currently c. 88%.

Bond yields have spiked higher, yield curve flatter

Bond markets have moved sharply on this. The 2 year Treasury yield has jumped around 15 basis points in the past 24 hours (to around 1.19%). However, we also see that the 10-year yield is only up by around 5 basis points, and is pulling back lower today.

This is a significant “bear flattening” of the yield curve (at the 2s/10s spread). This is broadly negative for risk appetite as it suggests that the tightening of rates will be negative for the economy in the years to come.

The impact on major markets

In forex, we are seeing decisive USD strengthening across the major pairs. Initially, this was just seen against the low-yielding currencies (JPY, CHF, and EUR). However, following the hawkish comments from Powell, we also see a decisive negative impact on the pro-cyclical AUD and NZD.

This USD strength has continued today and we are seeing the Dollar Index on the brink of a breakout to new multi-month highs. Above 96.94 would be the highest since July 2020 for the dollar.

A close on EUR/USD below 1.1185 support from the November low would be a key breakdown. It would also open the way towards 1.10.

In precious metals, there has been a considerable reaction to the spike higher in bond yields. Gold has moved sharply lower and is now testing support of a 6-week uptrend but also a higher low at $1805.

For indices, the key question is whether support can hold. The recent sharp selling pressure has given way to wild swings higher and lower in the past few sessions. An intraday rebound this morning gives hope that there is an appetite for supporting this weakness. 

On S&P 500 futures, the key low at 4212 may be supplemented by a higher low at 4263, however, the buyers need to push above 4445 to suggest a serious recovery is forming.