Fed meeting: the hawkish pivot that never was

The Fed’s latest meeting is over, and once more it has left its mark on financial markets. The Fed chair Jerome Powell’s press conference drove significant market moves, the 2-year US Treasury yield fell by 8 basis points, and is now at 4.95%, having been above 5% for most of Wednesday’s session. Stock markets were volatile and ultimately settled around flat for the day. At one point the Dow Jones jumped nearly 400 points. The dollar is lower across the G10 FX space, especially vs. the yen, although the BOJ may have intervened to amplify this move. The main message from this meeting is that the Fed is likely to keep interest rates on hold for the medium term, and Powell appeared to shut the door on future rate hikes during his press conference. The question to ask now, was the Fed dovish at this meeting, or is the market reaction a sign that it was expecting the Fed to be excessively hawkish?

Hawkish expectations dashed

The key takeaway from this meeting is that the tone was more dovish than expected, but that is because the rate hike hype in the US was over-egged, and rate cut hopes had been pared back too far in recent weeks. Market-based interest rate expectations have only shifted slightly in the aftermath of this meeting. There is now a chance of a December rate cut, with one full cut priced this year and a slightly larger chance of a second cut priced in post Powell’s press conference.

The other takeaway is that there is an incredibly high bar for a rate hike rather than a rate cut. Powell said that rates are restrictive at 5.25-5.5%, and it is unlikely that the Fed’s next move will be a hike. At the same time, the Fed is data dependent, and will not pre commit to rate cuts. This is the inherent tension for the Fed right now: rates are high enough, but they can’t pre commit to the next move because inflation remains volatile.

Contradictory moves, as the market can’t make up its mind about the Fed

This is why we are getting somewhat contradictory moves in financial markets on the back of this meeting. The 2-year Treasury yield fell 7 basis points on the back of this meeting, yet the gold price, the ultimate inflation hedge, rose by more than 1.2%, and is now less than $80 from its record high. The market reaction suggests that the market had been expecting too much of a hawkish pivot ahead of the meeting, which is why bond yields have retreated, yet there is still a residual fear that the Fed will lose the fight against inflation, and that is why the gold price is rising. This psychological tussle is taking place in the stock market: stocks initially rallied strongly on the back of the Fed statement, before retreating, suggesting that this isn’t the time for unbridled animal spirits in financial markets.

Bond yields fall as rate hike expectations priced out

The bond market sees this Fed meeting as being slightly more dovish than expected. We had flagged the possibility for a less hawkish Fed in our preview earlier this week. There has been a notable downtrend in US economic data in recent weeks, with an increase in negative surprises. This was evident in today’s ISM reports for April. The ISM manufacturing index fell back into contractionary territory at 49.2, the market had expected a reading of 50.0. The new orders index slumped to 49.1 and prices paid rose to 60.9, from 55.4, the highest reading since July 2022.

The economic backdrop along with an uncertain geopolitical backdrop, makes the Fed’s job harder in 2024, as growth seems to slow at the same time as inflation remains stubborn. The next test of the economy’s resilience will come on Friday with the release of the April NFP report. The ADP report was slightly stronger than expected at 192k, vs. 208k in March. While the ADP and NFP reports do not have a strong historical positive correlation, an NFP reading that follows the ADP and is below 200k, could be a sign that the US economy is slowing down, thus opening the door to rate cuts at some point this year.

The employment data is worth watching closely on Friday, as Jerome Powell said that now inflation is below 3% on an annualized basis (core PCE), the focus will shift to the labour market. Thus, traders may also want to see the latest NFP and wage data figures before making their mind up about whether the rally in risk assets can continue when the Fed is on hold indefinitely.

Fed triggers massive yen move

The push back on the prospect of rate cuts has weighed on the dollar and lent some much-needed relief to the yen. USD/JPY has dropped sharply and is down from 158.00 to 154.50 at the time of writing. The JPY is a significant outperformer vs. the USD in the aftermath of the Fed meeting. Although the USD Is down on a broad basis, it does suggest that the BOJ may have capitalized on the ‘dovish’ tilt at the Fed, and they could have timed intervention to boost the yen. EUR/USD is higher by a more modest 0.5%, while GBP/USD is up 0.3%, as traders look towards next week’s BOE meeting.

Us Debt load becomes the Fed’s latest problem

The surprise development at this meeting was the announcement that the Fed would slow down the pace of quantitative tightening – i.e., slow the pace of selling assets on its balance sheet. The monthly redemption cap will be reduced to $25bn from $60bn from next month. The timing of this announcement is interesting as it comes on the same day as the Treasury’s quarterly refinancing announcement. They are offering $243bn in Treasury securities this quarter, which is $41bn higher than the estimate in January due to lower cash receipts (taxes). Q2 tends to be a light quarter of debt issuance, and this is expected to surge past $800bn in Q3. The bulk of the Q2 financing is in 3-year and 10-year notes, with $25bn in a 30-year bond. This may have calmed the market’s nerves about the risks around a failed debt auction. However, the Fed also needs to factor in the massive Treasury issuance later this year into its decision making on interest rates. If rates remain restrictive for too long, then we could see a failed auction or stress in the money markets, which could cause stress in the global financial markets. This is why we think the Fed is likely to cut rates pretty quickly once the economic data turns, especially signs of weakness in the labour market.