Will Fed meeting lead to mayhem?

The Federal Reserve meeting on January 26th is a massive risk event. It’s always big, but this week could be even bigger than usual.

Stock markets are wobbling. Netflix was hammered after their earnings report, falling 20% after hours and shedding a casual $45 billion in value as it tumbled.

More big tech titans report this week too, with Apple, Microsoft & Tesla the highlights. Those three firms alone hold a 25%+ weight in the US100…

Some say an even bigger market correction is inevitable as the Fed withdraws monetary support. “Markets are addicted to liquidity and need to be weaned off” (or words to that effect).

Grizzled bears like GMO’s Jeremy Grantham sense that their moment has finally arrived. He’s calling for the S&P500 to fall by 50% (to 2500!) as the “superbubble'' pops… He’s been shouting at bubbles for a decade now though.

That said, the US100 has already fallen below the 200 day moving average:

FX volatility could pick up too. Especially in the USD & JPY pairs as markets digest the messaging and decide if the odds are leaning more towards ‘Risk Off’ or ‘Goldilocks’.

Lots to look out for at this meeting as the Fed lay out their plans.

Expectations

• QE to end early? Chair Powell’s comments to the Senate that “... the economy no longer needs or wants the very highly accommodative policies that we’ve had in place.” sounded very hawkish and potentially hinted at an even earlier end to QE.

There’s now speculation that those purchases could end even sooner with the end of QE being announced at this meeting. The program is currently scheduled to end in March.

Markets haven’t cared about QE for some time so ending this early would be more symbolic than anything else. Still, it would be an important signal for interest rate hikes and a way to prove they mean business.

• All The Hikes! Expectations are high. Markets expect a 25bps hike in March, with rates likely to increase to 1% by the end of December.

Over the weekend, Goldman Sachs strategists flagged the risks of the Fed tightening at every meeting from March onwards, and the potential for more than four hikes during 2022.

Why does this matter?

In a low inflation, low interest rate world, stocks with high future earning potential can trade at higher valuations. It’s another case of markets being forward-looking.

Basically, markets make assumptions about the future to assess the value of ‘growth’ companies. Those assumptions (persistently low interest rates & low inflation) are being tested now. Higher rates and higher inflation change the discount rate, potentially making these companies less attractive.

Many of these companies are highly indebted, so an increase in interest rates also makes their debt more expensive to service.

And the US100 with its 25x Price/Earnings Ratio is far more sensitive than, say, the Dow at 7.9x P/E

Bottom line: More hikes and higher bond yields could mean trouble for the US100.

Powell: “If things develop as expected, we’ll be normalising policy, meaning we’re going to end our asset purchases in March, meaning we’ll be raising rates over the course of the year ”

Will they go 50bps at the March meeting to “shock and awe”? According to the CME Fed Tool, traders are pricing a mere 5% probability of a ‘double hike’ so it seems unlikely…

Source: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

However, the fact that this is even spoken about is a symptom of the bigger illness currently affecting markets:

Uncertainty

Markets generally HATE uncertainty, especially the higher risk assets. And it’s not just any uncertainty! We’re talking about monetary policy in the country with:

1. The largest economy in the world
2. The biggest equity markets in the world
3. The global reserve currency

And this is why clear communication will be so important: To re-establish some feeling of certainty in markets.

Risk Off Or Goldilocks?

Let’s game out the scenarios:

At one extreme… Full risk off. The Fed has become more convinced that inflation will persist and interest rate hikes are the only tool that will do the job to bring it back down to earth. In this scenario, it would be typical to see a flight to safety: e.g. Bonds, Gold, USD & JPY appreciate.

At the other extreme… Goldilocks (not too hot, not too cold). The Fed sees more signs that inflation will slow in the second half of the year and insist that two or three rate hikes followed by a slow normalisation of the balance sheet (QT) will do the trick. In this scenario, it would be typical to see a moderate ‘risk on’ impact.

As always, the extremes are least likely and it will probably end up with some kind of messy compromise in between.

Some more clarity on this point would help too:

At some point perhaps later this year we will start to allow the balance sheet to run off, and that’s just the road to normalising policy.”

Saying “at some point” to markets is like telling the kids you’ll take them to Disneyland “one day”. They both want to know exactly WHEN.

It remains to be seen what all of this will mean for the dollar. Taking a look at the EURUSD chart, the price action is suggesting a move higher. The sequence of higher lows is a textbook tell for technical analysts.

But here again we can make the case for the other side. The failed rally towards 1.15 last week will encourage dollar bulls hoping for a move lower in the pair.

There’s a political angle too. By shifting the rhetoric as aggressively as they have, the Fed now has room to pull back slightly. It’s a balancing act between those extremes.

Communicating to the markets that they are concerned enough about inflation to act and maintain credibility is important as part of their price stability goals.

Communicating that they will only go as far as necessary to ensure that inflation slows (and no further) should ensure that hopes of a long lasting economic expansion are maintained.

This meeting is the first opportunity of the year to formally emphasise this point. The fate of equity indices (like the US100), and the dollar lies in their hands.

Not investment advice. Past performance does not guarantee or predict future performance.