The Federal Reserve tilts modestly hawkish, pushing front-end interest rates and the USD up
The Federal Reserve meeting delivered a modest hawkish surprise indicating that low-for-long is not low forever. The median FOMC member rate forecast (“dot”) for 2023 showed two hikes, up from zero in the last projection in March.
13 FOMC members out of 18 now expect an interest rate hike in 2023, up from 7 in March. 7 FOMC members now project interest rate increases in 2022, up from 4 in March, albeit the median estimate is still for near zero interest rates in 2022.
The reduction in pandemic-related growth risks due to significant progress on vaccinations, as well as changing risk assessments regarding inflation explain, in our view, the upward shift on the trajectory of optimal monetary policy. In the United States, circa 53% of the population has received at least one dose of (45% fully vaccinated) suggesting a diminishing effect of the public health crisis on the economy.
Equally importantly, following significant higher-than-expected inflation outcomes in the past two months, the number of FOMC participants seeing risks to inflation weighted to the upside, increased to 13 from 5 in March.
All told, the economic forecasts for 2022 and 2023 were little changed relative to March, indicating solid real GDP growth above trend (1.8%) throughout the forecasting horizon. The unemployment rate is expected to revert to pre-pandemic levels (3.5%) by the end of 2023.
At the same time, inflation is expected to decelerate slightly above 2%, following a significant spike in 2021 (3.4%). FOMC officials continue to stick by the transitory nature of the shock, albeit are less confident.
The “talking” about tapering its large-scale asset purchases has begun. Chair Powell noted that the conditions for tapering were still a ways off. The ongoing jobs shortfall of circa 7 million relative to pre-Covid levels suggests that the labor market still has a substantial amount of slack. Chair Powell also reiterated its commitment to signal tapering plans well in advance of the actual announcement. The Fed will try hard to avoid a repeat of 2013’s “taper-tantrum”.
Global assets demonstrated elevated volatility post the Fed meeting. Equities consolidated near all-time highs, with Cyclical equity sectors underperforming on the back of declining nominal long-term interest rates. Emerging market equities lost ground, as the US Dollar index (DXY) rallied to a 2-month high. Oil prices remained well bid ($75/barrel) due to strong demand as economies reopen.
US front-end interest rates sold-off and the yield curve flattened significantly as markets repriced Fed policy interest rate expectations in a hawkish direction. 2s and 5s US Treasury yields increased by circa 10 basis points (bps) to 0.3% and 0.9%.
The 10/2s term spread and the 30/5s term spread (a 9-month low) declined significantly, as the Fed appeared vigilant regarding inflation risks. Gold sold-off ($1783), due to rising real USD interest rates.