The Fed manages to toughen up its rhetoric without panicking the markets

Posted Jan 13, 2022, 6:19 PMUpdated on Jan 13, 2022 at 6:55 PM

The case seemed settled. Since the last Fed meeting in mid-December, the markets had integrated that they had to prepare for three rate hikes in 2022. Enough to bring the Fed funds, the key rates of the American Federal Reserve, to almost 1% at the end of the year. But in just a few weeks, the central bank has considerably hardened its rhetoric. In an interview with the “Wall Street Journal”, Wednesday evening, James Bullard, the president of the Fed of Saint Louis, even pleads for a fourth turn of the screw.

James Bullard is one of the voting members of the FOMC (Federal Open Market Committee, the monetary policy committee) this year. He had already been one of the first to call for a normalization of Fed policy in 2021. He spoke as inflation in December hit its highest level in 40 years, at 7% year on year. .

A more restrictive (hawkish) monetary policy than previously anticipated will be necessary, he says. He himself recently estimated that the Fed should raise its rates three times this year. “I actually think now that maybe we should go to four hikes in 2022,” he told the WSJ. Given the inflationary threat, he even considers it crucial that the Fed tackle it “as soon as possible”.

The markets could recall the good memory of the Fed

The reasoning is as follows: the faster the Fed acts, the less it will need to raise its rates over time. An essential point. Liquidity has fueled the rise in the markets so much that beyond a certain stage in the monetary tightening, the latter could remember the US central bank fondly. “Even if the Fed considers that the neutral rate for Fed funds (the one that allows non-inflationary growth, editor’s note) is around 2.5%, it will have trouble getting them above 1.5%, without the financial markets clipping its wings,” quipped Albert Edwards, Societe Generale strategist, well known for his bearish bias.

More rate hikes, faster? Several members of the Fed have come out in recent days in favor of an initial hike in March. Among them, Mary Daly, the president of the San Francisco Fed, generally considered a “dove” (favorable to an accommodating monetary policy) and Patrick Harler, the boss of the Philadelphia Fed.

Fed balance sheet

Asked how quickly she felt the Fed’s balance sheet should shrink, Cleveland Fed Chair Loretta Mester (classified as a “hawk”) also said, “Frankly, I would like to reduce it as soon as possible, provided that this does not disrupt the functioning of the financial markets. »

Some equate the Fed’s new zeal to fight inflation with Joe Biden’s declining popularity in the polls as Americans begin to suffer from the rising cost of living. One thing is certain: inflationary fears have overshadowed its concern to pre-announce its decisions a long time in advance so as not to surprise the markets. “The Fed’s communication has become much more aggressive in the space of a few weeks. A month ago, few were expecting a first rate hike in March,” remarks Vincent Juvyns at JP Morgan AM.

Well-negotiated turn

Despite this very rapid adjustment, the bond markets seem to be negotiating the turn well, “which is reassuring for investors”, underlines the strategist. After a first week of January marked by strong tensions (US 10-year rates rose from 1.51% to 1.76%), the market calmed down.

Many believe that a good part of the adjustment of long rates is now done. “There are significant restoring forces that will de facto limit the rise in long rates. Beyond 2% or 2.5% for the American 10-year, buyers of Treasuries will once again be attracted by the yields. As for the risks in terms of valuation [c’est-à-dire de baisse des prix, les rendements et les prix évoluant en sens inverse, NDLR], they will then become much less important,” explains Vincent Juvyns.

Gilles Moëc, the chief economist of the Axa group, explains in a note why he is maintaining his forecast of 2% at the end of 2022 for US 10-year rates. “A reduction in the size of the Fed’s balance sheet could be detrimental to risky assets,” he explains. Given the sensitivity of the US real cycle to wealth effects, this is not something the Fed could completely ignore. »

However, he underlines the risk that market rates “follow a bell curve this year and temporarily exceed the 2% threshold in the first half of the year, especially if the expected slowdown in inflation takes a while. »

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