Inflation-averse bond markets focused on the Fed’s tricky balancing act

FILE PHOTO: Federal Reserve Chair Jerome Powell testifies before a hearing of the US House of Representatives Financial Services Committee on Capitol Hill in Washington
FILE PHOTO: Federal Reserve Chairman Jerome Powell looks on as he testifies before a hearing of the US House of Representatives Financial Services Committee on Capitol Hill in Washington, United States, March 2, 2022. REUTERS/Tom Brenner

March 14, 2022

By Karen Brettell

(Reuters) – With the Federal Reserve almost certain to hike interest rates for the first time in more than three years this week, investors will focus on how it plans to stem a spike in inflation triggered by the Ukraine crisis without triggering a recession .

The US Federal Reserve is expected to at least raise borrowing costs at each of its next three policy meetings as it scrambles to tackle the fastest inflation in 40 years. Consumer prices rose 7.9% yoy in February.

But after waiting for the economy and jobs to safely recover from the COVID-19 pandemic, the Fed also risks tightening monetary policy while growth slows. Western sanctions punishing Russia for its invasion of Ukraine have pushed up prices for oil and other commodities and added to uncertainty about the trajectory of the global economy.

“The policy path taken will be another upside,” said Kim Rupert, managing director of global fixed income analysis at Action Economics, who added that Fed Chair Jerome Powell and his policymakers were likely to take a cautious data addiction approach. “You really can’t help it given the uncertainties caused by the war.”

Powell’s press conference after the end of Wednesday’s two-day policy meeting will be closely watched for any clues as to how aggressive the Fed might be in fighting inflation and whether it will risk a recession to dampen price pressures.

Fixed income markets are already betting on a possible future economic contraction, with the US 2- and 10-year Treasury yield curve flattening to just 25 basis points, a much narrower gap than at the start of previous Fed tightening cycles. An inversion in this part of the yield curve is considered a reliable indicator of a recession in one to two years.

The Fed’s benchmark overnight rate was 0.08% ahead of this week’s monetary policy meeting. Fed fund futures traders are pricing in a 1.75% interest rate by the end of this year. [FEDWATCH]

The Fed is also due to release updated quarterly economic forecasts and a “dot plot” showing policymakers’ interest rate forecasts on Wednesday. Markets expect the Fed to announce more rate hikes this year and possibly a higher terminal rate, with the neutral rate seen as consistent with full employment and stable prices.

“Our expectation is that they prioritize tightening over policy and likely want to slow down in 2023,” said Zachary Griffiths, macro strategist at Wells Fargo. “It will be interesting to see if policymakers start revising their expectations for the terminal rate in response to expectations that inflation this cycle may be a bit higher than what we saw during the last economic expansion .”

The new economic forecasts will reveal whether officials see a near-term easing in price pressures and the extent to which GDP growth expectations have been cut.


The Fed could also indicate how fast and large the cuts to its $8.9 trillion balance sheet will be when the bonds it holds roll off the books, which many analysts expect to happen in May or June.

The central bank is also widely expected to announce that it has ended the massive bond-buying program launched in early 2020 to contain the damage from the pandemic. Securities purchases have declined since November 2021.

In January, the Fed said it did not expect to sell its Treasury holdings, but instead let them mature without being replaced. However, it could sell its mortgage-backed securities, which could ease some of the pressure on hot housing markets.

Meanwhile, money markets will debate whether the Fed will hike the rate it pays investors to borrow Treasuries overnight in its repo facility by 25 basis points, or just 20 basis points after raising it by 5 basis points last June was raised to prevent short-term interest rates from falling too low.

That could impact demand for the Fed’s reverse repo facility, where investors borrow overnight Treasuries and which continues to post near-record daily volumes of around $1.5 trillion, said Padhraic Garvey, regional head of research for the Americas at ING.

A smaller rate hike on that facility could “wind up some of that excess cash flowing back into that window on a daily basis,” he said. Given that this is the first rate hike, the Fed may want to simplify messaging by keeping the 25 basis-point hikes consistent across rates and highlighting that more are to come, he noted.

The central bank twice increased counterparty limits on the reverse repo facility in the past year to address excess liquidity amid a lack of safe, short-term assets.

(Reporting by Karen Brettell; Editing by Alden Bentley and Paul Simao) Inflation-averse bond markets focused on the Fed’s tricky balancing act


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