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Wall Street snapped 4-day losing streak as Fed Chair Powell sounded less hawkish on QT timing in his renomination testimony

calendar 12/01/2022 - 19:22 UTC

On Tuesday, Wall Street Futures recovered from a deep plunge and closed in green, snapping 4-day losing streaks as Fed Chair Powell sounded less hawkish on QT (Quantitative Tightening/ Balance Sheet shrinkage/run-off) than some of his FOMC colleagues. In his renomination Senate testimony, Powell emphasized inflation control by QE tapering, successive rate hikes, and also QT. But Powell signaled that Fed will discuss the modalities of QT in the next two-four meetings and may go for the same later this year (2022).

This means that Fed will decide on QT by March or June’22 meeting, while several Fed Governors already jawboned the market for March’22 liftoff and QT soon after that. Thus USD slips, Gold, and equities jumped. And India’s Dalal Street may also dance to the Fed tune (Wall Street) on Wednesday and may soon scale lifetime high 18600 levels in the coming days amid earnings and budget optimism despite Omicron concern.

Powell told lawmakers during hits Senate confirmation hearing that he expects inflationary pressures (recently dismissed as 'transitory') to persist throughout much of the year. But Powell did not, however, suggest a more hawkish response to the fastest inflation levels since the early 1980s, noting only that he and his colleagues would be ‘humble but a bit nimble’ in executing rate hikes and taking any decision on running-off the Fed's $9T balance sheet.

Highlights of Powell’s testimonial Q&A on Tuesday:

·         I’m going to make climate scenario testing a very important priority

·         Much of the rise in inflation is due to pandemic-related disruptions

·         Our tools have no direct distributional effects, but a tight labor market has many advantages

·         The main thing the Fed can do is ensure that we have a robust labor market

·         We now have a mismatch between supply and demand

·         I don't believe it is necessary to realign all mismatches through the demand channel

·         We have to be humble and a bit nimble, while going for normalization

·         We will use our tools to reduce inflation

·         If inflation continues to be higher than forecast, we will have to raise interest rates more over time

·         It will take a long expansion to achieve a strong labor market

·         Price stability is required for a long expansion

·         We want to encourage a long expansion, which necessitates price stability, and high inflation is a threat to that goal

·         If we have to raise rates more over time, we will, but we  will probably remain in an era of very low-interest rates (even after normalization)

·         It’s generally a good thing that wages are moving up

·         Much of the inflation surge tied to pandemic-related disruptions

·         The economy no longer needs highly accommodative policies and if we have to raise rates more over time, we will

·         The employment situation is very good and the labor market is recovering at an incredibly fast rate

·         This year, we will return to a more normal policy and  this should not hurt the labor market

·         It's time for us to move away from pandemic emergency stimulus

·         We have no direct influence over supply-side conditions

·         We can impact demand but not supply

·         At the moment, we need to pay more attention to inflation than to the maximum employment goal

·         Supply-side limitations have persisted for a long time, and there hasn't been much progress on that front

·         We need to achieve price stability, I’m certain we'll be able to do so

·         We are likely to normalize policy this year, including raising interest rates, and we may begin balance sheet runoff later this year

·         At some point this year, probably later this year, the balance sheet will be able to shrink

·         We have a labor supply problem

·         The big threat to maximum employment is inflation levels

·         Inflation will decline over time, but the question is how fast

·         Inflationary pressures are expected to persist until the middle of this year; if inflation persists, policy action will be required

·         If inflation persists for a longer period, it is more likely to become entrenched, and our policy will adjust accordingly

·         I expect the Fed will raise interest rates this year, end asset purchases, and start allowing the balance sheet to shrink later this year

·         The Fed hasn't decided on a timeline for any of the normalization processes

·         Due to omicron, there may be decreased hiring and slower/negative growth, but it should be short-lived

·         The labor force participation revival has been slower than expected

·         Supply-side concerns have a big impact on energy and food prices, which the fed can't change

·         We haven't made any decisions on balance sheet reduction yet, but discussed it in the December meeting and will discuss it again at the forthcoming January meeting

·         The economy is in a completely different place than it was during the last tightening cycle

·         We will shrink the balance sheet sooner and more quickly than the prior time

·         It will take two to four meetings to work through the balance sheet decision (i.e. March-June'22); tends to take’ 2-4 meetings to make such decisions

·         The balance sheet is far above where it needs to be

·         We're a long way from being out of pandemic, potentially

·         Omicron could disturb supply chains again

·         The main thing we can do is foster a strong employment market, consistent with our price stability (inflation) mandate

·         The U.S. debt is unsustainable, and it is best to address it soon

·         Stablecoins could coexist with a CBDC

·         Report on digital currencies is ready to go; due to other priorities, the digital currency report has been delayed

·         The purpose of the digital currency report will be to solicit public feedback rather than to take positions

·         The report on digital currencies is ready to be released, we expect the report to come out in the coming weeks, but it will not take many positions on the various issues; if they do, our policy will continue to adapt

Earlier, before Powell, Dow/Nasdaq/S&P Futures were under stress on relatively more hawkish jawboning from some of Powell’s colleagues.

Fed’s Mester said on Tuesday:

·         Penciled in three rate hikes for 2022 at the December meeting

·         If the economy looks in March the way it does now will support moving rates up to at that meeting

·         Fed cannot ignore this short or medium-term tightness in the labor market

·         The Fed must take actions to bring inflation down given the environment it is clear that inflation is too high and the labor market is strong and the Fed needs to take action

·         The Fed will do all possible to maintain a healthy path for the economy

·         Financial conditions have tightened in the market

·         Given the current situation, I believe the Fed must take action to reduce inflation

·         I'd want to chart a course for the balance sheet that will result in less accommodation

·         The economy is now bolstered, and the balance sheet is considerably bigger

·         The fed should be able to run down the balance sheet faster than it did last time

·         The Fed's monetary stance has to be re-calibrated because inflation is higher than the Fed's expected level

·         The Fed cannot overlook labor market tightness in the short or medium-term

·         The fed will have to wait and watch how the economy performs overtime before determining how many rate hikes are required

·         The rationale for starting to wind down accommodations is very strong

·         Price rises have become more widespread

·         The economy is on a very good track and inflation is more persistent

Fed's George said on Tuesday:

·         The time has come to normalize monetary policy

·         Fed should draw down balance sheet sooner rather than later

·         Demand is robust, inflation is high, labor is in short supply

·         Markets could see volatility as the Fed normalizes monetary policy

·         The labor market appears to be tight

·         The Fed's present ultra-accommodative monetary policy is out of sync with the economic outlook.

·         In comparison to the previous tightening cycle, I believe it will be acceptable to go faster on running down the balance sheet

·         The coronavirus outbreak is likely to reduce labor force participation and prolong supply chain disruptions

·         COVID/Omicron outbreak is expected to further postpone the shift from goods expenditure to services

·         The power of economic fundamentals will maintain support for strong consumption growth

·         Economic activity, particularly expenditure, is more robust to fluctuations the pandemic

·         A tight labor market will promote investment in technology and more investment could take some pressure off wages

·         The extraordinarily large balance sheet cannot be overlooked

·         I’m going to make climate scenario testing a very important priority

Fed's Bostic said on Friday:

·         Wages and other labor market factors are consistent with full employment

·         Business executives believe they have pricing power and aim to utilize it; they also intend to restructure supply networks to be more resilient but more expensive

·         The entire balance sheet runoff process should be completed in a couple of years, and not drag on

·         March is appropriate for the first hike, and the balance sheet runoff should begin soon after

·         Sees three rate hikes in 2022, with risks pointed towards a fourth on the possibility of higher inflation

·         I’m open to the prospect of a March rate rise

·         Every meeting has the potential for some policy action and I’m open to march being a meeting where interest rate changes are considered

Further Fed’s Mester said on Wednesday:

·         Studies show that the Fed could reduce its balance sheet much faster without causing disruption, but the committee must still settle on a plan

·         Even if no aggressive selling occurs, the balance sheet will be reduced due to the maturation of holdings

·         Selling assets is one method that the Fed may employ, but I do not want to take anything off the table

·         The Fed should shrink its balance sheet as quickly as possible without disrupting financial markets

·         The Fed can lower the balance sheet faster because the economy is stronger and the balance sheet is at a higher place

·         The Fed has to set a suitable path for the balance sheet and then see what the effects are

·         The Fed must be careful and humble when attempting to quantify the impacts of balance-sheet decreases

·         The effects of balance-sheet reduction will vary depending on where the economy is at the time

·         The Fed will need to take policy actions to ensure that inflation expectations remain consistent with the 2% target

·         The rate at which interest rates rise will be determined by how the economy performs

·         The labor force participation trend is declining due to demographics, and we are returning to that trend

·         If things look like they do today in March I would support raising rates from zero at that point

·         The Fed is also reviewing what it can do to its balance sheet to reduce the level of assets

·         The rationale for removing accommodation is highly compelling

·         Depending on what happens with the economy some of the rate hikes further out may need to be moved forward

·         If we can get over the pandemic, inflation measurements will begin to fall

·         We've progressed from pandemic-driven inflation to something more widespread

·         Various factors are currently driving up inflation, including supply chain difficulties and pay increases

Also, U.S. President Biden again urged (Fed) to control inflation:

·         With price rises still too high and squeezing family budgets, the U.S. has more work to do

·         The U.S. is making headway in slowing the rate of price increases

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Conclusion:

Almost all Fed policymakers are now preparing the market for a March liftoff and QT from subsequent months (June/August). Fed is now actively discussing modalities of QT (passive/active runoff); i.e. whether Fed will actively sell its bond holdings in the secondary market or simply allow the bond to mature without reinvestment as the majority of Fed balance sheet now consists of short term bonds. If Fed chooses an entirely passive run-off over years, then QT will have minimal impact on the money market and bond yields may not soar.

But Fed has to hike to at least +2.5% and shrink its huge $9T balance sheet to at least $4.5T (around 20% of real GDP from present 45%; assuming $20T real GDP) by 2025 to control inflation and also to prepare itself for the next economic crisis. Fed may go for eight rate hikes in 2022-23 assuming the interest rate is its primary weapon. As QT is more serious implications for USD shortage globally, Fed will carefully operate it through a mix of passive as-well-as active runoff.

Fed speakers do not talk openly without a coordinated approach as a part of jawboning (forward guidance) to prepare the market for any imminent policy change. And as a matured policymaker, Fed Chair Powell always downplays any hawkish bias by his colleagues to ensure orderly movement of various asset prices; i.e. Powell & Co always tries to ensure financial (Wall Street) stability at any cost, be it during COVID or policy normalization after COVID. Thus Powell played his best on Tuesday in his testimonial Q&A, knowing fully about QT tantrums.

Overall, Fed Chair Powell sounded less hawkish than his colleagues on QT timing as a strategy for financial (Wall Street) stability, but Mar-June'22 still a possibility for liftoff and QT announcement. QT will start from Sep'22 (after two rate hikes) and the pace will be much higher than during last time (2017). All will depend upon the actual curve of COVID in the U.S., which is still parabolic and need to be flattened by Feb for March liftoff; otherwise expect June liftoff. Fed/Powell is under huge pressure from both the White House and Main Street/media to control inflation by controlling demand, which a Central Bank can do. But at the same time, the White House needs to ensure smooth supply, which may not be possible unless COVID flattened meaningfully and China came out from its ‘Zero COVID’ policy, normalizes supply chains.

Thus if Fed presses brake too hard, it may result in stagflation (lower economic growth, higher/elevated inflation, and higher employment (so-called ‘policy error’). History shows that, whatever may be the rhetoric, whenever the US mortgage rate goes above +4.5%, it causes an alarm bell for the next wave of recession (bond yield flattening). As Fed will never go for any NIRP, Fed will always normalize itself to prepare for the next GFC (global financial crisis), most probably by 2028-30 (usually every 10-12 years of boom/bust cycle). On the other side of the Atlantic (Europe/EU) as well as Pacific (Japan), ECB and BOJ consistently failed to normalize their crisis-era super accommodative monetary policies on the excuse of deflation. The policy divergence between Fed and ECB/BOJ will make USD stronger and help the greenback to remain as the ‘King’ (growth currency rather than funding currency).

As Omicron is more infectious and less hazardous (deadly), it may not impact economic activities/employment significantly. Still, Fed will wait for any sign for COVID curve plateauing/flattening to make the next policy move. So far Fed is using its strongest tool (jawboning) to control inflation expectations. In reality, Fed is still buying assets under QE but at the same time also trying to manage excess money market liquidity through active reverse repo (backdoor QE tapering/QT). The market is already discounted for three rate hikes in 2022. Now the Fed is preparing the market for a 4th rate hike in 2022 and another four in 2023 with QT from late 2022.

Bottom line:

Powell repeatedly said that Fed is dependent on US core PCE inflation, employment and also COVID curve. Powell also acknowledged that inflation is already substantially higher than Fed’s target and thus fulfills the rate hike condition. The same is almost true for the maximum employment front. Now the question is COVID/Omicron curve and whether Fed goes for liftoff in March or June’22 despite it looks parabolic. But going by the experience of South Africa or the even U.K., the Omicron curve is also expected to plateau by January in the U.S. and globally, the two years long pandemic may turn into endemic by June’22 amid huge natural as-well-as artificial vaccinations. This will pave the way for faster normalization by the Fed (3-4 rate hikes in 2022 and the start of QT).

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