Fed hikes by 50 bps, begins balance sheet reduction from June

The US Federal Reserve announced on Wednesday that the FOMC had agreed to raise the target range for the federal funds rate by 50 basis points to 0.75% to 1%, in line with expectations. 

The Fed further noted that it will begin trimming the balance sheet on June 1, starting with a $47.5 billion cap on monthly runoff and rising to $95 billion monthly after three months.

Key takeaways as summarized by Reuters

“Fed anticipates ongoing increases in target range will be appropriate.”

“Inflation expected to return to its 2% objective and the labor market to remain strong with appropriate monetary policy firming.”

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, broader price pressures.”

“Invasion of Ukraine by Russia is causing tremendous human and economic hardship.”

“Implications for US economy highly uncertain but in the near term invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”

“In addition, covid-related lockdowns in china are likely to exacerbate supply chain disruptions.”

“We are highly attentive to inflation risks.”

“Although economic activity edged down in Q1, household spending and business fixed investment remained strong.”

“Job gains robust in recent months.”

“Fed policy vote was unanimous.”

Market reaction

The US Dollar Index turned south with the initial reaction to the Fed’s policy announcements and was last seen losing 0.3% on the day at 103.12.

Buy the dollar dip? No limits for interest rates, nor for the currency

  • The Federal Reserve has raised rates by 50 bps as expected and seems open to further hikes.
  • QT program launch and its potential ramp-up make the dollar scarcer. 
  • Lack of hints about peak inflation adds to uncertainty, another positive for the greenback. 

“Our friendship has no limits” – that declaration from the presidents of China and Russia preceded the latter’s war on Ukraine. The Fed seems to be declaring war on inflation, leaving investors in the dark about how high-interest rates will rise. That is dollar positive, and so is the Fed’s flexibility on withdrawing greenbacks from markets. 

Buy the Rumor, Sell the Fact

The dollar is initially lower, due to several factors. First, a “buy the rumor, sell the fact” response. Second, the Fed refrained from promising an “expeditious” cycle, and without a promise to act fast, the algorithms seemed to have sold off the dollar. Third, the decision has been unanimous – uber-hawk James Bullard refrained from voting for even more aggressive policy. 

Nevertheless, I am certain this initial dollar selling is wrong. Let me elaborate: 

The Fed states that household spending and business fixed investment remained strong in the first quarter, despite an editing down in economic activity. On one of its mandates, employment, it stresses that “job growth has been strong in recent months.” 

What I see as most important, is the Fed comment on inflation: it is still high, “owing to supply and demand mismatches caused by the pandemic, rising energy prices, and broader price pressures”. The latter is the most critical point – inflation is broad-based

The world’s most powerful central bank raised interest rates by 50 bps to a range of 0.75% to 1%, as fully expected. The officials at the Washington-based institution also launched a Quantitative Tightening (QT) program, in which it lets bonds mature without reinvesting the proceeds, thus shrinking its balance sheet. 

While these two steps were fully priced in, the path of the next rate hikes and the final interest rates remains uncertain. If there is one thing markets hate is uncertainty. But for traders, this is a boon. “Make the trend your friend” remains the name of the game. 

Greenback attracts safe-haven flows

The dollar benefits not only from higher US rates but also from uncertainty, as the greenback attracts safe-haven flows

Before the decision, talking heads on financial media discussed a final rate of 3% to 3.50%, but the bank’s statement leaves no clue as to how high borrowing costs could go. Some certainty could come in June when the bank publishes new forecasts – but these are prone to abrupt changes.

Traders have to react with certainty despite an uncertain picture, and they try to scrutinize the Fed’s statement for direction. It seems like a war on inflation, a massive change from the days of describing rising prices as transitory. 

Despite the relatively moderate Core CPI figure for March – 0.3% MoM – there is no mention of price rises slowing down. Fog is hiding the peak of inflation, and that makes the upward climb harder for the Fed and for markets. 

The Fed fought the previous war of deflation back in 2021, and it might be too aggressive now. Nevertheless, Fed Chair Jerome Powell’s words matter more than one figure, which could be a one-off. 

Another factor to consider for the dollar is the number of dollars in circulation. It is not only about to fall via the current QT scheme but could further squeeze. Fewer greenbacks – and especially the specter of even fewer ones – mean a stronger currency.

Bottom line: the dollar rally has more room to run, as peak inflation and peak rates have yet to appear.

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