Fed Relief Rally Is False Dawn to Strategists Who Fear Inflation

(Bloomberg) — The collective sigh of relief in markets after Federal Reserve Chair Jerome Powell pushed back against super-sized hike speculation may be short lived.

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The worry is that absent tough action, markets face a toxic combination of persistently high inflation and slower growth.

While the Fed hiked rates by 50 basis points, the most since 2000, and flagged similar moves in coming months, Powell said 75 basis points was “not something that the committee is actively considering,” spurring a rally in stocks and bonds.

Traders had been increasingly betting that the FOMC would opt for an even bigger rate increase to quell the hottest inflation in decades, a move that would also have raised the risks of pushing the economy toward recession.

The S&P 500 Index had its best day since May 2020. Treasuries rallied, with yields on two-year notes retreating 14 basis points. The dollar declined.

Here are some initial reactions from investors and strategists:

Limits of Policy

Nancy Davis, founder of Quadratic Capital Management:

“The focus now shifts to the further 200 basis points of rate hikes expected during the rest of the year. These hikes are already priced in. We are puzzled why the market thinks that Fed hikes are going to stop inflation. We believe that there is little monetary policy can do to calm inflation in the near term. We see inflation as driven by massive government spending, supply chain disruptions and, more recently, by Russia’s invasion of Ukraine.”

Unintended Consequences

David Page, AXA Investment Managers’ head of macroeconomic research:

Market reaction “was interesting and highlighted the difficulties of gauging the required scale of future policy tightening. Even as the Fed chief was seen as fulfilling market expectations for rate hikes this year and galvanizing the broader economy for the effect of rate hikes, financial markets appeared to react to the fact that the Fed was not considering 0.75% hikes – something that was little more than a risk case – and lowered their expectations.”

“This marked easing in financial conditions was unlikely to be what the Fed hoped or expected from its press conference. Whether that reflected a myopic focus on 75 basis points rate hikes, or a more considered fear of economic slowdown the easier financial conditions raise the chance of more Fed rate hikes to come.”

Bull Steepening

Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets:

“We were encouraged by the bull steepening response in rates and the two-year sector rallying from 2.85% before the Chair took the podium to below 2.60% in the wake of his remarks as the more extreme hawkish pricing assumptions made their way out of valuations.”

“The steepening has room to run and we’re comfortable letting the price action play out over the next several sessions.”

With a path for the balance sheet runoff laid out, “we suspect the process will move to the background in terms of providing new tradable information.”

Don’t Rule Out Mega Hike

James Knightley, chief international economist, and Padhraic Garvey, regional head of research, Americas, at ING Financial Markets:

“Market pricing isn’t especially aggressive relative to history. It doesn’t look especially aggressive given the position the economy is currently in.”

“While the Fed likely won’t admit it, we’re convinced they will be taking a close look at the impact on long run inflation expectations post the FOMC.”

“The 10-year inflation expectation is just about tolerably below a 3% handle. The risk, however, is for inflation expectations to break above 3%. Should that occur, the case for a 75 basis-point hike in June would build. The immediate reaction has been muted, on both real rates and inflation expectations, but we need to continue to monitor this important space.”

“The FOMC’s focus on fighting inflation and front-loading rate hikes continues to point at a supported dollar in the summer months.”

Dovish Surprise

Jeff Klingelhofer, co-head of investments at Thornburg Investment Management:

“I was surprised to see a dovish statement slightly dismissive of inflation. In their hearts and minds, the Fed is clutching to the idea of transitory inflation — they just can’t say that out loud. At times, it feels like the Fed is super hawkish with off the cuff responses, but their tone changes to more dovish in official communications. I believe the Fed continues to think that much of their work is already done. They could hike more aggressively if their concerns about inflation are so high.”

High-Wire Acts

Stephen Miller, investment strategist at GSFM:

“Through a demonstrated complacence about the magnitude and momentum in inflation through 2021, the engineering of a ‘first-best’ solution might now be beyond the Fed. It is now engaged in the most delicate of central bank high-wire acts.

“Despite a more aggressive approach from the Fed, and temporary relief reflected in financial markets, they remain in a volatile phase as they assess the success of the Fed in reining in inflation without risking a substantial economic dislocation.”

Favoring Commodities

Alexander Saunders and strategists at Citigroup Inc.:

“Commodities outperform at this stage of a hiking cycle. Equities start to perform again mid-cycle after some initial indigestion, while credit remains pressured. Bonds should not be bought until the very tail end of the cycle. Broadly speaking, hiking cycles favor commodities, and are in line with underweights for bonds and credit.”

Expect Big Swings

Steven Englander, head of G-10 FX research at Standard Chartered Plc:

“Today’s tone shift is in line with our expectation that both inflation and activity will slow as 2022 progresses, and ultimately be reflected in a significantly lower fed funds path and USD level. However, until the slower growth trend is well established, the ups and downs of data could produce big swings in expectations and in the tone of Fed commentary.”

Rethinking Fixed Income

Rebecca Felton at Riverfront Investment Group:

“I think it was a collective sigh of relief across the board today.” Powell was measured and avoided hitting alarm buttons.

“We believe the worst is over for fixed income investors.” Riverfront is underweight fixed income but “will start rethinking that positioning here in the near term and that these are going to be more attractive asset classes.”

Equity Bottom

Tina Teng, a markets analyst at CMC Markets:

“I see a bottom has been reached in the broader equity markets as the Fed’s projection on its rate hike roadmap could not be more aggressive as what the markets had priced in. The U.S. inflation also shows signs of peaking. Powell’s comment of an economic ‘soft’ landing indicates a softening tone of the tightening approach.”