An overnight move in the US Dollar of one cent shows the market was caught at least partially off-guard by the Federal Reserve last night. Despite USD buying in the week approaching last night’s Fed decision, the market still had room to build long-USD positions as demonstrated by the latest CFTC data. The hawkish tilt that the Federal Reserve showed the market last night pushed stocks to close lower with the exception of banking stocks that welcomed the prospect of higher interest rates. The reason the Federal Reserve was able to wrong foot markets last night was because there was an emerging case for a bearish-USD outlook moving into the decision.
Moving into the event, the Fed had two real policy options in the face of rising inflation. Firstly, the Reserve could take the hawkish path, signalling a rate hike for its March meeting. The market was divided over whether it would forecast and deliver this but there was some positioning building for up to 50 basis points worth of tightening at the next meeting. The other option the Fed retained was to start sorting out its balance sheet, by cutting back the stimulus programmes accrued over the pandemic via-asset purchases.
Consider this play off as a good old mixer tap: separately controlled, one side hot, the other cold, the water coming out the spout reflects the combination of both components. Consider the hotter the water that flows the looser the monetary conditions and the cooler it flows, the tighter. The hot tap then becomes the interest rate mechanism: turn on the hot tap and you cut interest rates to a point where money becomes feverishly cheap. The cold tap is the balance sheet – most notably adjusted by QE – and represents tapering not tightening. The cold tap in this example is turned on by tapering and turned off when the central bank prints money.
To cool the temperature of the water and therefore take some steam out of the economy and rising inflation the Fed could either shut off the hot tap, or it could increase the flow of cold water in the mix. The latter, being a composition of cold and hot water would still be lukewarm and represent a dovish scenario where the bank only tapers the stimulus via the balance sheet and doesn’t forecast hikes. The real way to take the heat out of the water (and via the power of metaphor the economy) is to start turning off the hot tap! Okay it’s not quite an Archimedes moment but at least the parallel to the bathtub endured.
Yesterday there was rising speculation that the bank might only adjust the balance sheet for fear of suffocating the economic rebound in the United States. The move of the Federal Reserve, whose decision was delivered in a hawkish tone by its Chairman Jay Powell, was a resounding twist of the hot tap. Accordingly, five rate hikes are now priced into the US monetary markets over the course of 2022 raising the yield behind USD significantly.
Discussion and Analysis by Charles Porter