Key takeaways from FOMC decision

The FOMC raised rates by 25 basis points, in line with market expectations.

The Fed’s initial announcement was somewhat hawkish - “inflation has eased somewhat but remains elevated” though Chair Powell’s press conference was more dovish – “disinflationary process is underway with strong labor market.” And the bulls ran with that.

Sifting through the noise, my main takeaway is that the Fed still very much cares about inflation and Powell reiterated that the risk for the Fed comes from doing too little rather than doing too much.

This would suggest that the Fed still has some way to go with raising rates – while still hoping for immaculate disinflation without a weakening labor market.

Secondly, financial conditions have recently eased – though Powell brushed this observation aside. The US stock market has rallied and mortgage rates have come down.

I don’t believe that Fed wants to see this. Still, Powell did not emphatically push back when asked if he is concerned about financial conditions having eased.  Instead, he said financial conditions haven’t changed much since December.

He said he is not focused on short-term moves in financial conditions but instead is focused on “sustained changes to financial conditions” and that financial conditions have tightened a lot over a longer time frame.

Still, the risk comes from allowing financial conditions to ease when the inflation fight is not over yet. Powell did add that monetary policy is still not restrictive enough, and so the Fed expects ongoing rate hikes.

How have markets reacted?  What is our take on what is happening?

Markets became more "risk on" as the FOMC press conference unfolded. Equities rallied, with the NASDAQ leading the other major indices. Rates have fallen and the US dollar weakened. Markets clearly anticipate the Fed will be pausing tightening soon.

What is our outlook on the situation?

I believe markets are right in sensing that we are getting closer to an end of tightening by the Fed, that we likely have two more 25 basis point rate hikes before the Fed hits the "pause button". 

The Fed could even take a page from the Bank of Canada’s playbook and institute a “conditional pause” with tough language around re-instituting hikes if economic data is not satisfactory; that could perhaps be enough to ease the fears of Fed hawks that worry about ending tightening too soon.

Regarding possible rate cuts this year, I believe the market remains way too optimistic. The labor market remains tight – the latest job openings report listed 11mn new jobs or 1.9 openings for every 1.0 job seeker. ¹ This suggests that wage growth pressures are likely to remain for a while. 

What is our resulting investment strategy?

I anticipate volatility in the near term, but also expect an increasing global risk appetite as markets positively re-price recession risks, and ultimately look forward to and discount an economic recovery that could begin to unfold late this year.

Indeed, upgrades to global growth forecasts are already underway now that China is reopening earlier and more quickly than anticipated, and that Western Europe seems to be having inflationary growth rather than stagflation or recession as previously feared.

Fed dovishness combined with global recovery and tighter policy from other major central banks has the strong potential to push the dollar lower still, which in turn should boost global growth and risk assets in the US and around the world.

I continue to favor EM (particularly APAC EM) over DM given current valuations, a downwards USD trajectory, ensuing Fed pause and China reopening.    

What are we watching out for?  What are the risks to our view?

The main risk is that the path of inflation moderation going forward is not satisfactory enough for the Fed to hit the "pause button" soon, and that rate hikes continue for some time. (This could include alternating meetings between pausing and hiking, as mentioned in the press conference). 

A prolonged tightening cycle would increase recession risks and prolong the time before an economic recovery could start. This environment would favor defensive investment positioning.

Link to the original article by Invesco

Footnotes
¹Source: Financial Times. Data as of February 2, 2022.