The Federal Reserve somewhat caught the market off guard last night. The US central bank’s efforts in recent months to tame inflation have been nothing short of extraordinary. Late out of the blocks, the Federal Reserve produced last night its fourth consecutive interest rate hike of 0.75%. These enormous, oversized interest rate adjustments have taken their toll throughout the economy, unfortunately so far they have had only a limited effect on the measure they are designed to target: inflation. Accordingly, the Chair Jay Powell last night delivered a message the markets hadn’t wanted to hear: we’re not done yet.
The market had priced in a 75 basis-point hike which it was granted last night. No surprise there then. So why did USD based major crosses displace more than 2 cents peak to trough following the decision last night? Given the timing of this monetary policy decision as the fourth consecutive rate hike of 0.75%, a process which has added a whopping 3% to underlying US rates since the cycle started, markets had taken a what goes up must come down approach to US rates. Accordingly, whilst they had expected this decision to raise headline rates to the degree that was delivered they had been pricing in ever shallower adjustments for the meetings ahead. Up until the decision last night, the fixed income market was still even pricing in rate cuts as early as 2023 focussing on the growth implications that such a front-loaded tightening cycle would inevitably bring to the economy.
Recognising that this kind of rhetoric could be damaging to inflation expectations undermining the Federal Reserve’s efforts to tame inflation somewhat, the FOMC stamped out those expectations. This was done by the Chain by highlighting that the peak of US interest rates would likely be higher than the market was expecting leading to the conclusion that either rate hikes will continue to be more aggressive in size or extend further into the future than had been expected. These words drove the front end of the yield curve higher in the US attracting demand to the US Dollar and leaving it trading significantly higher moving into the European open. The Reserve somewhat suspended its data led approach at least with respect to inflation data. It is clear now that the size of future rate hikes may now moderate. However, from the press conference we know we can continue to expect more of them and further into the future until inflation is under control. This will increase the inversion of US yield curves and raise the expectation of recession in the US but still support shorter term USD valuations.
Discussion and Analysis by Charles Porter
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