Investors look for clues about interest rate hikes

Federal Reserve Chairman Jerome Powell testifies during a Senate Banking, Housing and Urban Affairs Committee hearing on the CARES Act, at the Hart Senate Office Building in Washington, DC, USA , September 28, 2021.

Kevin Dietsch | Reuters

This week, the Federal Reserve is expected to broadly announce the unwinding of its monthly bond buying program – a move it has begun to support the economy during the pandemic. However, the bigger story for the markets is how the central bank will discuss inflation.

Indeed, report after report, higher than expected inflation has bolstered expectations that the Fed will fight the upward trend in prices by starting to hike interest rates next year, about six months earlier than expected. the latest Federal Reserve forecast.

Economists expect the central bank to say after the conclusion of its two-day meeting on Wednesday that it will start cutting its $ 120 billion in monthly bond purchases by mid-November or December and will end the program entirely by the middle of next year.

Fed Chairman Jerome Powell has made a point of emphasizing that the end of the program does not signal the start of a new cycle of rate hikes, and he is expected to repeat that message during his post-meeting briefing on Wednesday.

But already, traders are anticipating more than two interest rate hikes for next year, while the majority of Fed officials don’t even see one in 2022 in their most recent forecasts. That’s because inflation, now at a 30-year high, has gotten hotter and appears to linger longer than the “transient” or temporary description the Fed had included in its recent policy statements.

“I feel like the word ‘transient’ has left the station. I would be shocked if we heard that word come back again,” said Rick Rieder, director of global fixed income investments at BlackRock. He said it will be important to watch how the Fed approaches jobs, the other half of its dual tenure.

Rising inflation and wages

Inflation, as measured by the personal consumption expenditure price index, rose 0.3% in September, bringing the year-over-year gain to 4.4%, the fastest since January 1991 .

Companies, which struggle to find workers, are also increasing wages to keep and attract employees.

“I think it’s the hottest job market since World War I,” Rieder said. “We had the highest [employment cost index] print since 2004. Wages are accelerating dramatically, and I think the Fed is lagging behind. I think they have to open the window to raise the rates. “

Rieder said he didn’t expect the Fed or Powell in their post-meeting briefing to discuss raising federal funds rates from the current zero level. The federal funds rate, which is set by the central bank, is the interest rate at which banks borrow and lend each other on a day-to-day basis.

“There is clearly a movement towards the Fed recognizing that inflation is more rigid than they thought,” Rieder said. “I think [Powell] will present data… that they anticipate that some of these inflation numbers are going down, and I think he’s right. “

But Rieder said the Fed must show it would be willing to raise interest rates if necessary. According to CME FedWatch Tool, traders see a 65% chance that the Fed will start raising interest rates by a quarter point in June and a 50% chance of a second hike in September, with a third also possible.

Relaxation is the first step

The Fed took unprecedented steps to quickly ease policy when the pandemic struck in early 2020. The Fed quickly cut rates to zero and the bond buying program was instituted to quickly provide liquidity to markets.

The reduction in bond purchases, or quantitative easing, will be the first unwinding of a major program. The Fed is expected to make it abundantly clear that it will slow its purchases of $ 10 billion per month treasury bills and $ 5 billion per month mortgage securities.

A wild card for the Fed has been Covid itself, and the delta variant outbreak is largely blamed for the sharp slowdown in growth in the third quarter. Gross domestic product only grew at a rate of 2%, just a quarter of what some economists expected for the period to start the year. While the Fed is likely to recognize a slowdown in growth, economists are already seeing it pick up in the current quarter.

Mark Cabana, head of U.S. short rate strategy at Bank of America, said it was possible the Fed could say it could speed up or slow its reduction process if necessary.

If the central bank talks about increasing the pace, as some Fed members favored a faster pullback at the last meeting, it could affect the market. “This only increases the risk that the Fed will end up looking hawkish,” Cabana said.

Interest rate

Powell probably won’t talk about an interest rate hike, but he probably won’t discourage market recognition of rate hikes either.

“The first rate hike is scheduled for July … It’s too early for the Fed to push back the hikes. It won’t tell the market it’s wrong,” Cabana said. “There is a risk of upward inflation. They don’t know for sure how inflation is going to play out.”

Rieder said he doubted Powell would talk about the potential for faster reduction. “My hunch is that this is not being considered today, but if he said we could decline more quickly, the markets would interpret this because they are considering raising rates earlier and / or more aggressively,” he said. he declared.

But no matter what Powell says about the link between tapering and buying bonds, the main interest of the market is inflation and the interest rate movements it could trigger.

Diane Swonk, chief economist at Grant Thornton, said she expects the Fed to be forced to hike rates next year.

“Our own forecast has a core PCE … peaking above 4% by the end of the year and slowing to 3.5% by mid-2022. The unemployment rate is expected to drop in below 4% in the first half of 2022, “noted Swonk. “These changes would result in a faster cut and faster rate hikes than the Federal Reserve announced in its September forecast. Market participants are now expecting three rate hikes next year, we could see some. more.”

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