Hawks begin circling the Fed
Corporates | Kennett Square, PA
The Fed holds short-term rates steady but indicates rate hikes in 2023. The Fed’s inflation expectation revised upward to 3.4%. Equities fall, dollar strengthens, and 10-year Treasury rates are mixed. The U.S. economic recovery continues.
Economic conditions are continuing to improve within the United States, with 65% of adults fully vaccinated. As the economy creeps towards normalization, the Fed began indicating to markets that tapering and rate hikes are on the horizon. In standard Fed fashion, no definitive dates were provided, but the dot plot indicated rates are expected to increase by late 2023. The Fed will continue to tolerate higher inflation and increased their headline inflation expectation to 3.4%. Interestingly, when asked about the inflation timeframe the Fed uses to target average inflation, Powell responded by saying there was no definitive look-back period. In other words, the market does not know and cannot estimate how much inflation the Fed will tolerate before increasing rates. The Fed continues to maintain that inflation is transitory and expects it to subside in the short term. For now, the Fed will keep the target federal funds rate between 0 and 0.25% in an effort to achieve maximum employment and average inflation of 2% over the long run.
The market's reaction
Despite Powell stating, “The dots are not a great forecaster of future rate moves,” the market reacted strongly to a potential rate hike in late 2023.
With lackluster retail sales, housing starts, and initial jobless claims this week, equities seemed primed to drop on any news of more restrictive monetary policy. The Dow Jones Industrial Average had its worst week since October 2020 and dropped 3.45%. Meanwhile, the S&P 500 closed the week down 1.91% and the NASDAQ Composite closed the week down 0.28%.
U.S. dollar index
With the dot plot indicating the Fed will raise short-term rates in 2023, which is faster than anticipated, the dollar strengthened. Since interest rates are expected to move higher, dollar demand grew as foreign investors chased potentially higher U.S. interest rates.
U.S. 10-year Treasury
Treasury yields initially spiked on the Fed’s news of higher anticipated rates. However, as investors digested the Fed’s meeting, they seemed to agree that the Fed was taking inflation more seriously and lowered their inflation expectations. When inflation expectations fall, real yields improve and investors pay more for treasuries. As investors moved to buy treasuries on lower real yield assumptions, they increased treasury prices and decreased yields. The 10-year treasury yield closed lower for the week at 1.44%.
Gold futures hit their lowest levels since April because of the Fed’s commentary. Gold is commonly viewed as a hedge against inflation. Therefore, investors sold gold when they began to collectively agree the Fed was taking inflation more seriously.
Lumber futures also fell dramatically this week with prices down 47.87% from their May highs. DIY projects and construction has slowed as consumers shift their focus from home improvement to vacations and other activities previously unavailable during the pandemic.
Takeaways for corporations
If corporations have FX exposure or are anticipating debt issuance, they need to keep an eye on both tapering and inflation.
Long-term rates are currently being held down by quantitative easing and a continued message of sustained low rates from the Fed. When tapering begins, long-term rates and the LIBOR/SOFR curves will be expected to drift upward. If inflation continues to persist at above average levels, the Fed may act to increase rates ahead of their 2023 forecast.
(Related insight:, Read, "Managing interest rate risk on future debt issuances")
From a historical perspective, when the Fed tapered bond buying back in 2013, emerging markets became extremely volatile. This is something to keep in mind when tapering begins again. FX will also be impacted if the Fed increases rates ahead of 2023 due to inflation. Should this occur, the dollar will be expected to strengthen.
(Related insight: Watch or read, "Operational FX hedging programs and the one leading practice you can't afford to ignore")
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