Markets agree with Powell but only up to a point

September 30, 2021 06:00
Photo: Reuters

There are three key takeaways from the September FOMC meeting, in our view: First, the new dots suggest a more hawkish policy path, with three-and-a-half rate hikes implied by the end of 2023, compared to only two in June. Half of the Fed officials see lift-off taking place in 2022, and only one official expects rates to be still at the zero lower bound in 2023, compared to five previously. Officials also see another three rate hikes in 2024, though these have to be taken with a ‘big’ pinch of salt given how far ahead they are.

Second, this hawkish tilt was in line with the significant upward revision to the inflation projections. Inflation is also expected to be slightly above target in 2024. Nonetheless, Jay Powell argued that these new projections largely reflect more persistent bottlenecks. To us, this message is somewhat at odds with the revisions. If the higher inflation forecasts were only due to longer-lasting ‘transitory’ factors, there should be no need for additional tightening. In our view, this suggests that for a majority of Fed officials, there are more than just transitory factors that are likely to keep inflation relatively elevated.

Finally, Mr. Powell has made clear that conditions for tapering have pretty much been met. A November announcement is almost a certainty, unless the September jobs report turns out to be very weak. It also looks like the Fed will be done with ‘the taper’ at around the middle of next year, in line with markets expectations. In short, tapering has been so well telegraphed that when it eventually happens, it will probably be a non-event for markets. Powell has also said that there will probably be some flexibility in the pace at which the FOMC tapers. If inflation is more persistent, it will accelerate the tapering (and vice versa). This implies that even if the labour market remains the top priority of Fed officials, they will not allow inflation expectations to become unanchored on the upside.

Market expectations for policy rates up to 2025 increased slightly compared with before the FOMC meeting, while expectations beyond that date actually decreased. The market continues to be at odds with the Fed’s estimated policy rate trajectory beyond 2023, implying that investors expect the US economy to be far less resilient to higher interest rates than Fed officials do.

Consequently, the 5y/30y curve segment flattened by 6bp to 96bp, a level last seen in August 2020, while the 2y/10y segment remains comfortably above 100bp. As we pointed out previously, flattening pressure in this segment will only become more persistent once we get close enough to lift-off. At this point, the 2-year yield should reflect a tighter expected policy. But we are not there yet and we will probably first experience some re-steepening if 10-year yields experience some upward pressure in Q4.

Mr. Powell has again underlined the importance of long-term inflation expectations remaining anchored. Consequently, 10-year break even rates remained fairly stable, while real yields rose in line with higher Fed Funds expectations. Still, real yields remain at the low end of what we expect.

The latest messages from the FOMC confirms our view of contained inflation expectations and somewhat higher 10-year yields, led by the real rate component and ongoing flattening pressure in the 5y/30y segment in Q4.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin