Markets embrace lengthy Balance Sheet runoff debate, Fed readies March hike, Oil rallies Gold Shines, Bitcoin higher
US stocks went on a rollercoaster ride after Fed Chair Powell’s testimony signaled that the Fed “in all likelihood” will be normalizing policy, while allowing the balance-sheet runoff later this year. The Fed sees inflation lasting till mid-2022 and that is probably when they will let the balance sheet decline.
Wall Street now has a better understanding on how the Fed will normalize policy and with the balance runoff likely taking up to four meetings. After Powell’s testimony, some investors feel they got the all-clear signal to buy the dip. The Fed’s window for tightening is complicated given inflation could finally peak during the summer and since they may not want to look political and be too aggressive removing accommodation so close to the midterm elections.
Investors are still very optimistic about three key things: Household and corporate balance sheets remain very healthy, the upcoming earnings season should be strong, and the economy will still see above trend growth even if the Fed raises rates three times and begins the balance sheet runoff in the summer.
The opening act to Fed Chair Powell’s confirmation hearing for a second term had a couple hawks, Bostic and Mester both lay the foundation for a March liftoff, while George supported an earlier balance sheet runoff.
Early this morning, Fed’s Bostic told Bloomberg, “We are ready to act to make sure that inflation does not run away from us.” He added that they “should be comfortable and looking to reduce the balance sheet fairly soon after we do our interest-rate liftoff”.
Fed’s George said, “My own preference would be to opt for running down the balance sheet earlier rather than later as we plot a path for removing monetary accommodation.”
That was a very hawkish opening act that should support the idea rates liftoff in March and the balance sheet reduction starts in June.
Fed Chair Powell’s testimony started with addressing inflation. He reminded financial markets that supply side constraints have been very durable and persistent, highlighting the number of ships in anchor are at record levels. He explained why they were wrong about inflation being transitory, noting that the situation is unprecedented.
Powell believes the Fed will take steps towards normalizing policy this year. Wall Street knows rate hikes are coming and expectations are now up to 85% for a March rate hike.
Regarding the labor market, Powell stated, “what we have is a labor supply problem.” The Fed can check off the maximum employment box and now just focus on inflation.
Powell noted that a decision on balance sheet reduction could take anywhere from two to four meetings, which suggests the June meeting will become the base case for many traders.
Overall, Powell was not overly hawkish as he paved the way for a lengthy debate over balance sheet reduction, with his normalization comments taking away some of the importance over tomorrow’s hot inflation report.
Crude prices rallied alongside risky assets after Fed Chair Powell signaled a lengthy debate over the balance sheet runoff. A long road to normal means the economy will still see a lot of support over the first half of the year and that is good news for crude prices.
Oil prices seem poised to trade between $80 and $100 a barrel as the global demand outlook still looks upbeat as most major economies are getting closer to the other side of the omicron fence. NY Gov Hochul said, COVID rates are plateauing in NYC, but that hospitals are still under much stress.
WTI crude is poised to make a run towards last year’s highs if stockpiles continue to decline.
Gold prices rose as the bond yield rally paused as Fed Chair Powell signaled the Fed is likely to begin normalizing policy this year. Gold forecasts for the year are all over the place, with most economists/analysts anticipating weaker prices as higher interest rates and fresh record highs for equities might dent demand for the precious metal.
The reason why gold will outperform is not a clear one, but it seems unlikely that the back-end of the Treasury curve will see yields go significantly higher once we get past the first couple rate Fed rate hikes.
While the economy looks very strong this year, possibly headed for a GDP reading above 4%, next year could be a quick return to near 2% growth, which has it vulnerable to a wide range of risks. As the Fed tightens conditions, we will see large pockets of froth struggle and the risks of inverting the curve will grow. The longer gold stays above $1800 the more annoyed the shorts will become.
Fed Chair Powell’s confirmation hearing provided another update on the heavily anticipated cryptocurrency report, which is now expected within weeks. Bitcoin was volatile during Fed Chair Powell’s testimony, settling higher alongside all the other risky assets. Risk appetite returned on Wall Street after Fed Chair Powell signaled he expects the Fed to begin normalizing policy this year, but that a decision on balance sheet reduction could take up to four meetings. The path of inflation may drive quicker rate hikes and a sooner start to shrinking the balance sheet and that could be bearish short-term for risk assets such as cryptos, but equities will likely feel more pain.
There is still significant money on the sideline waiting to buy Bitcoin, but many crypto traders are having a wait-and see approach to see if some potential death cross patterns trigger a major selloff.
This commentary is provided by Edward Moya Senior Market Analyst, The Americas OANDA