Improving economic forecasts for global and US growth in particular have been captivating markets in recent weeks as we have spoken extensively about. The main impact has been to drive up the yield on US debt to reflect the increased inflation and growth that lies in store for the US economy. Before the US Fed announcement and press conference by Chair Jay Powell, the generic US ten-year note reached post Jan-2020 highs in excess of 1.65%. His testimony, however, did not address the rising risks of inflation that the market has been increasingly sensitive too and accordingly US central bankers took no monetary action akin to the ECB last week, to address the rising bond yields in the US. Holding rates close to zero, the Federal Reserve’s expectations for interest rates out to 2023 and the future beyond barely changed with a meagre two (out of 17 total) additional members expecting a rate rise above previous forecasts by the end of 2023.
There are two possible interpretations of this monetary policy decision and in the 12 or so hours that have unfolded since the decision was made by the US monetary authority, we have seen both. The first interpretation is for the market to take the Fed’s predictions of underwhelming inflation below target over the medium run at face value. It is therefore to concur with Chairman Powell that inflation later this year will be transitory and more accommodative policy is required to stimulate the economy during the bounce back from the pandemic despite the additional fiscal stimulus that Biden’s Presidency has so far provided. If the market steps back and believes the Fed that inflation is not an issue and tapering is not something that is required at this point and policy is where it should be for now then yields would fall, value be released from the Dollar and stocks rally on the back of easier market-derived credit conditions.
The other interpretation is for the market to stick to its guns and continue to forecast higher inflation alongside the upward revisions to GDP growth that we have seen so far this year. From this perspective the Federal Reserve has allowed the fuel of easy monetary policy to continue to spill into the fire of an economy positioned to overhead with above target price inflation. Under this interpretation the Fed has opted deliberately to fall behind the curve and leave itself vulnerable to be led by, rather than leading, the market. If the market sticks to its forecasts of higher inflation in the coming years and the need for tapering and the removal of stimulus in a boom cycle, yields would continue to rise, encourage further demand into now non-negligible USD interest and risk the kind of equity market correction that has been forecast at higher levels.
Last night, outside of European trading hours, the Federal Reserve delivered its monetary policy decision. The immediate knee-jerk reaction last night was more stimulus, equals lower yields for longer, weaker Dollar and outperforming equities. Scenario one therefore played out, pushing EURUSD back towards 1.20 and GBPUSD towards 1.40 overnight. As the European open began to wind up this morning, however, the second scenario began to take hold. The market realised that lower for longer actually exacerbates their projected inflation overshoot and undermined the demand for US treasuries at current valuations and pushed yields higher. The 30-year generic US note pushed on further to exceed August ’19 highs. This higher yield and a reversal in the market’s interpretation saw the Dollar claw back some strength once again as the 10-year note hit new post-pandemic highs in excess of 1.75%. The market is therefore betting that the Fed will have to blink at some point. Until it does, the Dollar should continue to strengthen in line with rising yields and the bet that the US will have to normalise policy first.
Discussion and Analysis by Charles Porter