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 Federal Reserve still behind the curve

Post Federal Reserve meeting (26th January), the market prices in a faster pace of rate hikes than one per quarter, with the odds of a 50 basis point rate hike in March rising to 50% as priced in swaps. A key message from the chairman was that “We’re probably going to end up doing quite a bit more than people had anticipated.”

Quantitative Tightening – that is the reduction in the Fed’s balance sheet – will logically start sometime after the March meeting which is very much live, but not confirmed. The pace of reduction will be at a faster pace than it was in the first episode of 2017 confirming what many participants said at the previous Federal Reserve meeting (FOMC). This surprise on the path of interest rates and the balance sheet suggests that the pressure on equity markets is not high enough yet for the Fed to react to it. They are more concerned about the impact inflation has on average households which are far less invested in the stock market than the top 5% of earners.

The question is when will the Fed stabilize expectations in the interest rates market, taking into account that inflation momentum is still strong with rents likely to surge. That suggests it may take another few weeks, possibly up to the March meeting, to understand fully the Fed’s path. The real question though is the pace of tapering of the balance sheet as it can have a momentous impact on equities and the repo market (seizing up in Sept 17th 2019 after the end of tapering in March 2019). That probably depends on how consumers, corporates and landlords react to the Fed’s hawkish message ahead of the midterm election.

What does it mean?

In such an environment of volatility, we are reminded of the value of flexibility in multi-asset solutions. It is also a reminder that the ECB’s inflation problem not anywhere near as concerning as the Fed’s, so European equities continue to be an appealing prospect. Indeed, a rotation from US Tech to European equities is often heard from sell-side analysts.

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