FOMC: Not yet ready for rate hikes
The US Federal Reserve delivered the much-anticipated announcement on tapering in the November FOMC meeting. The muted market reaction reflected that the tapering announcement was largely in-line with expectations. Global equities hit new all-time highs and the 10-day realized volatility for the S&P 500 index is just at 6.5%. In addition, US 10-year yields, the dollar and credit markets traded steady in tight ranges.
The Fed would begin the tapering by scaling back the $120bn asset purchase program by $15bn/month and is expected to conclude in June next year. Assuming this pace, Fed’s balance sheet would end up at just under $9 trillion.
Fed Chair Powell reiterated that inflation is being driven by factors that are expected to be transitory including supply/demand imbalances. FOMC expects inflation to come down between 2Q22 and 3Q22, setting the stage for a slow timeline for hikes. The committee indicated that "similar reductions in the pace of net asset purchases will likely be appropriate each month, but it is prepared to adjust the pace of purchases if warranted by changes in the economic outlook." This obviously provides a lot of flexibility for the Fed. Additionally, Chair Powell made it clear that rate hikes would be tied to economic outcomes and the maximum employment test. This, coupled with the Bank of England decision to keep rates unchanged, led longer-dated yields to fall somewhat and the curve to flatten.
Having said that, the market is not yet convinced either by the FOMC’s stance on not being ready for rate hikes or of the view that inflation is “largely reflecting factors that are expected to be transitory”. While broad markets have been very well behaved, the volatility in front-end yields has been unusually large over the past two weeks as markets have adjusted to the gradual tightening. In the US, the market is still pricing in nearly a full hike by June 2022 and nearly three full hikes by the end of 2022. Furthermore, we have seen some extreme dislocations in short-term rates in the UK, Poland and even in Sweden.
Figure 1. Target rate probabilities for June 2022 FOMC meeting
Target rate (in bps)
Source: CME, AIM Capital estimates.
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