The reappointment of Fed Chair Jerome Powell sparked some unexpected volatility across markets, led by a jump in Treasury yields. But should we really expect Jay to be that hawkish?
What happened?
This week, US President Joe Biden reappointed Fed Chair Jermome Powell to serve a second term. In doing so, he rejected Lael Brainard, who will instead serve as Vice Fed Chair.
Brainard was the other frontrunner for the post and had been backed by some Democrats for her stance on banking regulation, while there was also simply a call to wipe the slate clean from Donald Trump’s pick. Politics aside, Brainard is seen as a more dovish candidate than Powell -- having previously called for a more cautious approach to tapering and raising interest rates.
The going logic is that with Powell confirmed to remain in the job, there is more certainty around tapering and tightening. As a result, markets priced in a more hawkish path for Fed funds rates.
The kneejerk reaction
Bond yields rose on Tuesday, the day after the nomination. The yield on the two-year note climbed to 0.62%, from 0.58% on Monday. Benchmark 10-year yields rose to 1.65% from 1.63% Monday.
The move in yields saw the dollar index touch fresh 16-month highs (EUR/USD new 16-month lows) and tech stocks to drop, leading to an underperformance in the Nasdaq.
Looking at Fed funds futures, markets are now pricing in a May or June 2022 rate hike. In our view, there is a clear risk that markets are getting ahead of themselves.
Will Powell hike rates in June 2022?
There are some reasonable assumptions backing this view.
Track record
To his credit, Jerome Powell is not one of the many central bank heads who went their entire time at the top without hiking interest rates a single time. Much to the chagrin of former President Trump, Powell did raise rates as the US economy picked up pace and the unemployment rate fell in 2018.
Lifting the US out of ZIRP came shortly after the Trump tax cuts provided the kind of fiscal stimulus that left ultra-accommodative monetary stimulus unnecessary. Now history might be about to repeat itself following Joe Biden’s soon-to-be-passed $3 trillion spending boost geared towards infrastructure, social issues and climate change.
With Congress doing its fair share of heavy-lifting to boost the US economy as the economic recovery matures, the Fed has arguably been given the green light to pull back.
Inflation
Consumer price inflation touched a three-decade high in October at 6.2% year-over-year and the general public, businesses and politicians are paying attention. The Fed has been calling inflation “transitory” for months but has conspicuously dropped this language from recent communications.
Fed minutes this week showed rising ‘stagflationary’ concerns. That is to say there was a belief that there are downside risks to growth forecasts and upside risks to inflation forecasts. The Fed has a dual mandate so there is more room to ignore high inflation than at other CBs but arguably 3-decade high inflation can’t be ignored for very long.
Despite these compelling reasons for earlier rate hikes, there are also good reasons for doubt.
Slowing growth
The economy is always going through cycles of various duration. While we are optimistic for the medium term as covid-19 turns from pandemic to endemic, we see the global economy, including the US, slowing into next year. It’s possible that fresh government spending will offer some cushion to the slowdown but much of the spending is planned over years, so cannot replicate the ‘stimulus check’ influence of 2020/21.
If the economy is slowing, which in itself typically cools inflation and inflation expectations, it calls into question why the Fed would want to aggressively hike rates next year.
Abating supply shocks
If the rapid inflation that is currently being witnessed globally is as a result of global supply shortages and not overheating domestic demand, then rate hikes will not solve the problem. In fact, if rate hikes cool an economy already grappling with supply issues, it could exacerbate the problem and add to the risk of stagflation.
Covid: another strain
European stock markets saw sharp declines on Friday (26th) amid concerns about a new strain of coronavirus dubbed B.1.1.529. It was detected in South Africa and some scientists say it is a concern because of its spread among young and vaccinated people.
Several European countries have already instigated harsh new covid restrictions for the holiday period. Some have designed lockdown-like restrictions to coerce the unvaccinated into getting the jab. These policies will inevitably be counter-growth and offer another reason to cloud the economic outlook.
What next?
We expect benchmark 10-year Treasury yields to remain under 2% into 2022. While a June US rate hike is feasible, we think the first lift-off could come later in H2 and that the subsequent glide path will be slower than current consensus.
The benefit the US dollar has received from widening spreads with Europe and Asia could close if market expectations for the Fed shifts. However, our view on the USD is neutral because of its properties as a haven were economies to experience another shock.
