Here’s why the market can get it wrong about the Federal Reserve and interest rates – .

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Here’s why the market can get it wrong about the Federal Reserve and interest rates – .


Traders on the floor of the New York Stock Exchange.
Source : NYSE
Monday’s aggressive stock market rally came amid fears from a Wall Street firm that investors still don’t like how quickly the Federal Reserve could start raising rates.
After being hammered in the last three trading days last week, Wall Street came back with a vengeance with a move that pushed the Dow Jones Industrial Average up more than 1.5%.

“The market is returning to its comfortable mode,” Mohamed El-Erian, chief economic adviser to Allianz, told CNBC’s “Squawk Box”. “Growth is strong. They still think inflation is transitory. They think the Fed is going to be relatively slow to shrink [monthly asset purchases], and that’s why you see higher “actions”.

This optimistic view of Fed policy is a mistake, according to Hans Mikkelsen, Bank of America credit strategist.

The Federal Open Market Committee last week concluded with officials saying they are now forecasting two rate hikes as early as 2023, faster than the market expected.

But Mikkelsen’s point of view is that tightening monetary policy could come even sooner.
“Expect the Fed to start cutting back soon [quantitative easing] purchases and start raising interest rates sooner than expected – and above all much faster than current market prices, ”he said in a note to clients.

The bank’s analysis noted that the committee was only “two points,” or two 18-person committee members’ projections, away from pulling the first rate hike in 2022. The panel turned split evenly over whether rates are expected to move next year, while eight members saw up to three hikes for 2023.

Taken collectively, members’ sentiment on the direction of policy has offered a significant departure from what has been a historically easy Fed.

Mikkelsen said the credit market, which has cut rates sharply despite the hawkish Fed, misunderstands the direction the central bank is taking. From a market perspective, he sees only a 41% chance that the Fed will hike rates by July 2022, according to CME’s FedWatch tracker.

“The main pricing error in the rate market, as our rate strategists continue to point out, is not the decrease, nor the timing of the first rate hike, but the pace of increases from there. moment, which is far too low compared to normal. hiking cycles in the past, ”he wrote.

Mikkelsen pointed out that the Fed has indeed already started to scale back its efforts to unwind the small portfolio of corporate bonds it bought during the Covid-19 pandemic. The move, “which was 100% unexpected because the Fed has a bad track record of selling assets – was a signal that the Fed feels increasingly encouraged to step out of its super-easy monetary policy, even if it does. means defying market expectations ”.

Changes in the Fed

For their part, Fed officials say the landscape is indeed changing, as evidenced by the dotted projections released on Wednesday.

New York Fed Chairman John Williams in a speech on Monday reflected the consensus view when he said he viewed inflation as transient and Fed policy appropriate given the current and expected conditions.

“It is clear that the economy is improving at a rapid rate, and the medium-term outlook is very good. But data and conditions have not progressed enough for the FOMC to change its monetary policy to support strong economic recovery, ”Williams said in prepared remarks.

But within the Fed, opinions differ.

St. Louis Fed Chairman James Bullard rocked the market on Friday when he told CNBC he was one of the FOMC members who thinks a rate hike in 2022 would be appropriate. Bullard is not a voter this year but will be next year.

But Dallas Fed Chairman Robert Kaplan said Monday he was focusing more on curbing the pace of bond purchases – by slipping – for now, and sees the rate question as a response to another day.

“I’d rather see us act sooner rather than later on asset purchases, and then we’ll make a decision in 2022 and beyond on what additional steps are needed,” said Kaplan, who appeared jointly with Bullard for a discussion presented by the Forum of Official Monetary and Financial Institutions. “But I think the issue on the table today and in the near term is the timing and adjustment of these purchases. “

The two officials noted the progress the economy is making and believe the inflation that has arisen in recent months may be a little more rigid than the Fed had expected.

“With the supply-demand imbalances, we think some of them will resolve within the next six to 12 months,” Kaplan said. “But again, we think some of them are likely to be more persistent, driven by a number of structural changes in the economy. “

For example, he cited changes in the energy industry – a key component of Kaplan District – towards sustainable energy as contributing to more lasting inflationary pressures.

Bullard mentioned the evolution of the labor market as an important consideration for the future policy of the Fed.

“We have to be prepared for the idea that there are upside risks to inflation,” he said. “Certainly, the anecdotal evidence is overwhelming that this is a very tight job market. “

If these inflationary pressures are stronger than Fed officials think, it would force them to tighten policy faster than they would like. This would hit the stock market and the economy in general, both of which depend on lower rates.

A tight Fed would drive up borrowing costs for a government that has experienced a spending spree over the past year and wants to do even more with infrastructure.

“At the moment, inflation is transitory. But if you stack it on top of other big stimulus, you run the risk of making something transient permanent, ”said Joe LaVorgna, Natixis chief economist for the Americas. “So you are in a really difficult situation. I think the Fed’s best approach is to say less. “

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