"...Maybe it's all part of the plan"
- Ed Sheeran, Thinking Out Loud
Financial markets are phenomenally innovative. History suggests that as far back as the collapse of the Roman Empire, contracts for the future delivery of commodities were actively used and even likely traded. More sophisticated derivatives such as options contracts are thought to have developed through the Tulipmania of 17th Century Europe. Now, following the extraordinary global monetary (and fiscal) response to the Coronavirus pandemic, it is possible that markets are in essence trading ‘thought derivatives’ – or trying to price the criteria, timing and impact of the point at which Fed Chair Powell begins “thinking about, thinking about raising rates”!
Heading into this week's FOMC meeting, expectations were … well, derivative. There was no realistic expectation of a rate move or increase in the asset purchase amount. Rather, expectations focussed around:
(i) the Fed’s forward guidance – or the formal narrative intended to push back on rate normalisation expectations through a commitment to maintain the current level of accommodation until certain criteria have been attained;
(ii) the extent to which the events since September (further economic recovery, vaccine breakthrough, Presidential Elections and even the recent virus surge) have altered the Summary of Economic Projections (SEPs) of the Committee;
(iii) lastly, there was also some expectation that the Fed may look to counter the recent steepening of the yield curve, by signalling intent to extend the Weighted Average Maturity (WAM) of their asset purchase (QE) portfolio holdings.
Ultimately however, the Fed left rates and the WAM unchanged, electing to guide monetary policy through new outcome-based forward guidance on its asset purchase programme.
The Fed pledged to “continue to increase its holdings of Treasury securities ... until substantial further progress has been made toward the Committee's maximum employment and price stability goals”. However, in the Q&A, Powell made it very clear that (at least at this stage), the Fed will not commit to firm criteria that would constitute such ‘substantial further progress.’ In this regard, the Fed’s new forward guidance on asset purchases essentially amounts to the commitment that they will continue with the current pace of QE asset purchases (at least USD 80B US Treasuries and at least USD 40B MBS), until, of course, they don’t.
Furthermore, some analysts expected that more FOMC members would forecast rate hikes by 2023 in their rate projections (or ‘dots’), and while the fact that just one additional member joined the ‘23-hikers club, the overall tone of the SEPs was significantly more positive than the September forecasts – the unemployment rate forecast at the end of 2021 was lowered to 5.0% from 5.5%, GDP raised to 4.2% from 4.0% and inflation raised to 1.8% from 1.7%.
If we bring together the Fed’s expected rate path, the new forward guidance pledge and the updated economic projections, the narrative is arguably very simple. The Fed is determined to run the economy ‘hot’ in order to overshoot its inflation target – “moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent”. In doing so, the argument can be made that the maintained, front loaded monetary accommodation and a normalising path of inflation expectations should drive lower real US yields and undermine the USD.
In the near term, we concede that this is likely the dominant force in FX as the Fed’s asymmetric monetary approach should drive risk (higher yield) seeking from markets. What is clearer to us however, is that the current Fed policy to run the economy ‘hot’ on the back of a continued rebound from the restrictions of 2020 should be a core driver of continued US equity gains and while the consensus likely looks for the rotation back into value from growth to dominate as we move into 2021, we ultimately continue to see (likely US and China led) tech innovation and take-up as the core driver of global growth.
My last thought on the matter is that as we move into 2021, I expect markets to begin to look more closely at how the underlying growth dynamic, credit scarring and debt loads shape the recovery. As Powell suggested, while the Fed has the ability for further monetary accommodation through increasing the size or duration of asset purchases, it is fiscal support that is needed now. As the vaccines and thus recoveries take hold, I expect that clear economic winners will appear and for FX markets those with the least obstructed path to monetary normalisation likely see resurgent currency outperformance – as growth and yield differentials widen. The USD may be on the back foot at the current juncture, but I for one am thinking about thinking about buying.
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