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Stocks were on the back foot early Monday as attention shifts to this week’s vital Federal Reserve meeting, as well as supporting acts in the shape of ECB and BoE. Shares across Europe opened lower after Asia mainly slipped, though China rallied as it reopened following the lunar new year holiday. The dollar traded firmer as it consolidates just above a 10-month low, while gold eased off after hitting its highest since April last week. Bitcoin has pulled back a touch after touching its highest since August over the weekend. Japan’s 10yr bond yield nudged up to 0.483%, close to the 0.5% limit set by the BoJ after starting last week below 0.4%. Oil pulled back further away from the 100-day line to its weakest level in a couple of weeks.  

Despite the weakness this morning for risk assets, global stock indices are set to close to the month firmly higher. The FTSE 100 is up around 4% this month but lags peers after a much more resilient 2022 than most. The Nasdaq is up around 11% and the DAX 8% higher in January as investors looked through signs of economic weakness and instead decided that peak inflation was behind.  

All eyes are on the Fed and what it says about the future path of monetary policy. Two key things remain unknown – how high and for how long. I don’t think even the Fed knows the answers to these questions at the moment, but it will undoubtedly want to push back against the dovish read the markets have taken.  

The Fed raised rates by 425bps last year with an aggressive series of hikes. Now markets think it’s ready to slow right down with a 25bps hike on Wednesday, taking the target range to 4.5-4.75%. Slowing but not stopping seems to be the message – officials have been consistent in saying there is more work to do.  

Fed governor Waller’s comments from Nov ring out still: “We're at a point we can start thinking maybe of going to a slower pace … we're not softening...Quit paying attention to the pace and start paying attention to where the endpoint is going to be. Until we get inflation down, that endpoint is still a ways out there.”  

But the market thinks otherwise – futures point to the market thinking the Fed will stop between 4.75-5.0%, in other words one more 25bps in March after 25bps on Wednesday. Markets are also pricing in cuts later this year. But Fed officials, by way of the dot plot, think the terminal rate will be some way above 5% and stay there for all of 2023. I think even they are underestimating the scale of the problem and a 6% level is eminently possible. Ultimately, I think on Wednesday they will prefer to slow to 25bps but this is not the same as a stop and pivot – my belief is the market is mispricing the terminal rate and misjudging how long the Fed will keep them there before it cuts.  

US GDP expanded by more than expected in the final quarter of last year, however this might be the last positive print for a while as there are clear signs of deceleration at the start of 2023. Final sales to consumers rose just 0.2% in the fourth quarter and fixed investment declined 6.7%. January PMIs are in contraction territory. There are signs that the Fed’s hikes are starting to have an impact, albeit the labour market remains tight, partly for structural reasons.  

The question is to what extent the Fed will be guided by a contracting economy if inflation remains too high. So far, the Fed has made it clear it will fight inflation come what may and I don’t think this is about to change – it can and will look through soft economic data until inflation is tamed. The labour market is different, of course, since the Fed has a dual mandate. This remains in fairly good shape and although some leading indicators within the labour market suggest it could be rolling over, it remains structurally tight.  

Inflation has shown clear signs of cooling. PCE inflation has fallen from 6.3% in September last year to 5.0%, whilst core PCE inflation has declined to 4.4% from 5.2% over the same period. The thinking is that disinflation allows the Fed to slow down and signal that a final 25bps in March could be its last for now. However, slowing is not the same as coming down to target and the Fed is saying to the market that it won’t pivot soon. The setup seems to allow the Fed to slow and check the rear-view mirror. Looking forward, there are signs that inflation is broadening and become embedded to a degree that will force the Fed to push on further. Commodity inflation may be rearing its head again. Moreover, PMI data on prices will worry the Fed. As per Chris Williamson at S&P Global - The rate of input cost inflation accelerated into the new year, linked in part to upward wage pressures, which could encourage a further aggressive tightening of Fed policy despite rising recession risks.  

Minutes from the last Federal Open Market Committee meeting show most members reckon they should start slowing the pace of rate hikes soon. This was not a significant surprise, if indeed it’s surprising at all. Mostly we knew that the Fed was wanting to take its foot off the gas a bit as we round the corner of the year into 2023 to allow time to take a look in the rear-view mirror to see if the economy was catching up with the breakneck pace of hikes. One of the reasons I think the Fed sticks to a hawkish line is the market interpretation remains so dovish – pricing in cuts this year when the dot plots don’t suggest this at all. The Fed does not want to see further loosening in financial conditions – not yet.  

QT – will the Fed signal boost quantitative tightening? In short, no. The Fed could actively start selling bonds but this would cause significant disruption in the market. I think the Fed is quite happy with QT chugging along in the background without too many ructions or tantrums. Any talk about juicing QT would spark significant volatility in rates. So we await with interest any talk about this since the Fed must surely be annoyed that long-end rates remain so persistently low, running counter to its hiking. The 10yr remains stubbornly at 3.5% and a nod to doing something with QT might push this rate up, so it could be an option for the Fed to try to get the market closer to where it’s thinking. 

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