FOMC: Wave Goodbye to The Punchbowl

Written on 27/01/2022 by Lukman Otunuga, Senior Research Analyst at FXTM

And that volatility may not calm after the latest FOMC meeting saw Fed Chair Powell strike a relatively aggressive tone with regard to policy normalisation. This time is different it seems, and Powell will follow through in order to tame worryingly persistent inflation.

To begin with, it’s worth setting the scene going into last night’s meeting. This year has been one of the worst ever starts to the year for stock markets. The S&P500 is touching correction territory, down more than 9% on a closing basis from the top earlier this year. A market pullback of 10% would be the first since the peak of the pandemic crisis in March 2020. Not only have we seen red blazoned across our trading screens most of the year, but the fall near to 10% on an intraday basis has been one of the fastest ever, taking only 15 trading days. And talking of intraday volatility, Monday was only the third time in history that the broad S&P 500 index was down 4% at the lows but finished higher. It has been some ride already this year, and yet more volatility is very probable.

Yesterday’s price action took a similar topsy-turvy turn, with markets looking positive heading into the key Fed meeting. In fact, the statement was fairly benign with the FOMC explaining the need to start tightening soon and an orderly unwind of the balance sheet. But the talking then started and Chair Powell was in aggressive mood. He said the economy is stronger than at the start of the previous tightening cycle, inflation is running hotter, and the jobs market is tighter. All of these differences have big implications for the correct pace of policy adjustment, especially in terms of interest rate hikes.

Four straight rate moves now look conservative, and many Wall Street houses are revising their calls upwards. Indeed, Powell refused to rule out more and stronger rate hikes. Does that mean we can rule out quarterly guided 25 basis point moves? Interestingly, the bond markets shot higher last night with the two-year Treasury yield enjoying its biggest one-day rise, save the one day during the pandemic blowout, since 2008 and the GFC. Perhaps more importantly, the actual yield curve, the spread of 10-year over two-year Treasury yields, flattened and is now flatter than at the beginning of last year, despite all the drama since then. In simple terms, bond traders believe that rates will need to rise in the short term but won’t have to stay high.

Aside from rate rises, markets are also having to digest the eventual winding down of the Fed’s balance sheet. Let’s not forget as part of its emergency bond buying programme, the central bank more than doubled its assets to nearly $8.8 trillion over the past two years. The resulting boost of financial liquidity has directly correlated with an expansion in valuations in stock markets. This huge punchbowl of stimulus is now being withdrawn, and policymakers don’t have much experience doing this. To borrow a phrase from the legendary Warren Buffet, “only when the tide goes out do you discover who’s been swimming naked.”

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