Investors try to make sense of the Fed’s ‘dot-plot’

Posted 18 June 2021

The biggest event of the week took place on Wednesday, as the US Federal Reserve (Fed) concluded its two-day Federal Open Markets Committee (FOMC) meeting, where it discussed economy policy and its latest projections on inflation and interest rates. Leading up to Wednesday, we were asking ourselves the question “what will the Fed change?”. In essence the choices were “nothing”, “a bit”, or “more than a bit”. All of us were somewhere between “nothing” and “a bit”. The Fed delivered “a bit”.

Yet the markets had some quite strong moves. The US Dollar rose sharply, by about 2% against most currencies. In bonds, the five-year yield rose to 0.88% from 0.75% and stayed there. The 30-year maturity bond rose to 2.22% but then reversed down to 2.10%.

Meanwhile, equity prices edged higher with tech shares in the NASDAQ getting the biggest boost and heading up to all-time highs again.
Ahead of the FOMC meeting, US inflation data had been a bit stronger than expected, but still mostly explainable by temporary virus effects, employment data were reasonable but showed a slower pace of improvement. Money markets remained awash with government, company and household cash. With the vaccination programme doing well and risks well contained, things were probably a bit better than expected at the previous meeting.

In his post-meeting press conference, Fed Chair Jerome Powell acknowledged that its so-called ‘dot-plot’ showed that there could be two rate hikes in 2023, with only a small likelihood of any rate rise next year. He sought to downplay its significance. He said the Fed expected solid employment improvement in the second half of 2021, and that inflation projections showed inflation back down to 2% by 2023. He also gave the gentlest of indications that bond purchases will slow at some indefinite point. (It also moved two minor interest rates up, but neither of them will tighten monetary policy).

The Fed’s credibility is always a contentious topic, and this has been especially so after such a huge episode of money printing. Surely, the more they print, the less we should trust them? Isn’t this the reason for Bitcoin? So, the sharp flattening is interesting, and continues the move lower in the “term premium” we mentioned last week. Real yields, as priced by inflation-linked bonds have stayed stable, which has resulted in market estimates of inflation going down a bit.

When you add in the rise in risk-asset prices, it all says that the Fed’s credibility remains huge. The market is pricing the outcome that the Fed wants: higher inflation followed by stable inflation around the target; profitable companies; trust in the government’s creditworthiness; an ability to keep the dollar’s value not too weak, not too strong. Its moderate path is on track.

Of course, the Fed might make a policy mistake, but it may be more the markets’ problem if inflation data is challenging. It’s all very well saying price rises are transitory when consumer price inflation is at 3.5% but if inflation is at 5% year-on-year, consumer inflation expectations may be less anchored. Half the market may think tightening is in order, the other half may think that would be a mistake. Whatever the Fed did, the market reaction could be substantial, if this week’s moves are anything to go by.

Having sent some signals at this point, the Fed will probably not do anything further as we head through the summer. Investors, both retail and institutional, will probably be desperate to take the holiday denied to us all last year. Markets may get very quiet. However, headline inflation will almost certainly look like it is rising, while an improving global economy may involve money being taken out of savings. By the time we get to the end of August’s big central bank get-together at Jackson Hole, there could be a lot of tension building up.

Of course, long-term investors shouldn’t worry too much. The Fed indicated that things are going pretty well, and we think the Fed is credible. Of course, we reserve the right to change our minds in the future.

There’s a fly in the ointment for the UK. The chart in the Japan article shows how exports have plummeted since the start of 2020, from around 32% to 25% relative to GDP. Of course, GDP is not up over the period, which tells us exports have been horrendous. At its heart is the fall-off in exports of services to Europe. There may well be impacts from COVID, but the Brexit process has left the UK in a weaker position, especially around the world of finance. The financial services balance had not worsened greatly as of the end of 2020, but we would usually see a big benefit from the improvement in financial activity in Europe. Instead, new capital raising is happening almost as much in Frankfurt as it is in London. The recent strength of sterling will be very difficult to sustain if our current account balance does not improve in the next twelve months.

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