This week has been a very interesting week in many respects; the ongoing UK Prime Minister ‘Ambushed by cake’ partygate saga, the Italian Presidential Election, the ongoing and seemingly escalating tensions between Russia and the West over Ukraine (not to mention the divergences between the US and Europe over the context of their agreement on the situation). However, despite the fact that there was no explicit change to policy, the most significant impact on markets likely came from the Federal Reserve (Fed).

Going into the meeting, the market had begun to question the ability of the consumer to absorb the level of rate hikes needed to get inflation under control. In other words, the combination of an ‘eye-popping’ inflation rate and a short period of US downside surprises on high frequency economic data have propagated the view that the Fed’s intent (need) to tighten financial conditions to address supply driven dislocations will be detrimental to the demand side of the economy. This concern has been exacerbated by the decline in equities over recent weeks. Ironically, in some respects, the concern over the prospect of the Fed tightening financial conditions has led to declining equity markets – a move which has itself been the biggest contributor to tightening financial conditions!

Specifically, expectations for the meeting were that the Fed Chairman could, but would likely not (i) announce an early end to QE, (ii) raise rates, (iii) prepare the markets for a 50bp hike in March, or (iv) suggest or announce that balance sheet reduction could take the form of active sales (rather than passive runoff). These concerns were by and large avoided.

In the eventuality, the Federal Open Markets committee (FOMC) left rates unchanged and the statement made three things very clear: (i) “Asset purchases will be concluded in early March”, (ii) “it will soon be appropriate to raise the Funds Rate” and, (iii) “balance sheet shrinking will start after hikes commence” - all within the context of a further elevation of the prolonged risk of inflation through the global supply/demand imbalance.

However, the Fed Chairman gave a more nuanced narrative. We have some thoughts:
On inflation, the Chairman’s press conference made it clear that the Fed are behind the curve on inflation (despite still easing policy through QE purchases, which are not due to end until early March). This was outlined not just through the explicit statement that “the inflation situation is ‘slightly worse than at the December meeting” nor the fact that the Chairman said that his own forecast of inflation would be a few tenths higher than December, but also through the clear warning that supply side concerns have grown via Omicron and that the risks have moved further to the right on inflation.

By extension, the Chairman was clear to encourage expectations of a pace of rate hikes faster than those implied by the December ‘dots’ (3 hikes in 2022), and refused to rule out 50bp increases, alongside the view that every meeting in 2022 remains live (there are 7 more); the Fed will remain nimble and able to respond to different outcomes.

On balance sheet reduction, there was relatively little other than the desire for the Fed to significantly reduce the balance sheet in a way that it would run in the background (and in a passive not active way), leaving the policy rate as the primary tool for adjusting accommodation.

On the economy however, the Chairman was more positive. While, in his opening statement, he referred to the near term weakness in growth (from the effects of the Omicron wave), he also referred to the prospect of a return to faster growth on reopening, post the Omicron wave - “if the wave passes quickly, the economy will return fast”. This is central to our glass (more than) half full view of the US (and global) economy. Further, while the Chairman talked about the need to move from unprecedented accommodation levels to a significantly less accommodative stance, and at some point in the future a point of no accommodation - he did not suggest that the Fed have in any way considered restrictive territory for monetary policy.

In terms of the labour market dynamic, the Chairman was even more positive - “The Labour market is very, very strong”, and that “the unemployment rate is the least tight measure of the labour market”, with substantial room for rates to rise, before impacting the labour market itself.

Lastly, the Chairman referred a number of times to FOMC desire to provide a platform for a very long expansion and that the best means to foster this was through price stability. This is also more aligned with our way of thinking about the US expansion: mid cycle, not late!

In essence, the Fed are (belatedly it could certainly be argued) addressing the significant inflation overrun and are doing so by accelerating expectations of near-term policy tightening. In this respect, a number of market moves make a lot of sense. For example, a rising US yield curve makes sense in this context, with repricing of rate hikes at the front end and risk premia / balance sheet reduction at the long end. By extension the continued widening of the 2y EUR vs. USD rate differential is in our view a key support for the USD vs. EUR, and we are more inclined to expect an accelerated (and renewed) USD uptrend vs. DM currencies, after a period of calm or stability.

However, where we disagree with the current dynamic is in the equity space. The idea that the “economy will return fast” post the Omicron wave is more in line with our thinking of a very strong underlying growth trajectory in the US, one Powell referred to as significantly supported by past fiscal (even if the fiscal impulse reverses in 2022) and past monetary accommodation. If we look at this in conjunction with the likely very modest terminal rate of US interest rates and the continued reduction of equity risk premia from the global transition from pandemic to endemic, the outlook for US equities is much more positive. This is not to mention the circular argument used against Equities (lower equities = tighter financial conditions = stronger equity headwinds) also works in the opposite direction.

Perhaps ‘Beautiful’ is the wrong descriptive narrative for the USD, or for that matter the US stock market, but after a period of uncertain direction, in our view one direction now seems clearer!