Hawkish Fed Spooks Markets

Federal Reserve wide angle on blue sky

At the close of business last Friday, global equities were sharply lower on the week after hawkish rhetoric from the US Federal Reserve and the European Central Bank dispelled the notion of a dovish central bank pivot any time soon. The yield on the 10-year note was little changed at 3.52% while the price of a barrel of West Texas Intermediate crude oil rose $1.50 to $74. Volatility, as measured by the Cboe Volatility Index (VIX), rose to 23 from 22.50 a week ago.



We received very good CPI news on Tuesday in the United States as the Consumer Price Index rose less than expected for the second month in a row in November. The first of the interest rate increases in the US is now showing up as inflation numbers begin to come down. There are still 3 more 75 basis point interest rate increases, which will impact the economies in both the US and Canada in the coming months and we expect inflation to fall significantly as we enter the first quarter of 2023.

With this news, we expected a pivot from the US Federal Reserve, but we received a continued hawkish stand. This rattled the markets, resulting in a sharp selloff. The markets hate uncertainty. Despite the comments by the Federal Reserve, we expect they are actually done. As inflation continues to decline in 2023, we believe it will provide a strong backdrop for a market rally in both bonds and equities in North America.



At the start of the week, I think it was fair to say we were expecting the traditional Santa Claus rally to happen. Historically, this has been the case for Canadian equities. The comments on Wednesday by the Federal Reserve in the US dashed those hopes. The bond markets are now indicating an increased risk of recession in the US and this spilled over into the Canadian markets. The silver lining is that markets are significantly oversold and with expectations of inflation coming down hard as we enter 2023, we can expect a strong rally in both bonds and equities.



The Fed delivered the half-point rate increase that the market expected on Wednesday but surprised investors with hawkish forecasts for its terminal rate and for inflation. The fed funds target band now stands at 4.50% to 4.75%. The median forecast by members of the FOMC rose to 5.1% in 2023, higher than the median of 4.6% in September. Despite softer inflation readings in recent months, the committee raised its outlook for core PCE inflation to 3.5% from 3.1%. At his post-meeting press conference, Fed Chair Jerome Powell stressed that in 2023 the central bank will not focus on rate cuts but on making policy restrictive enough to bring inflation down to its 2% target. Despite softer inflation readings recently, Powell said the Fed has “a way to go” to return to price stability and that labour markets remain extremely tight. Futures markets show that investors remain skeptical that the Fed will raise rates as much as they forecast or hold them at peak levels for as long as they now envisage.



After the ECB raised its deposit rate 0.5% to 2% on Thursday, the central bank’s president, Christine Lagarde said that investors should expect additional half-point hikes “for a period of time” and that the ECB needs to do more than the markets are pricing. The central bank raised its 2023 inflation forecast to 6.3% from September’s estimate for a 5.5% rise. Inflation risks, Lagarde said, are primarily to the upside while growth risks are to the downside. Quantitative tightening will begin in March at a measured, predictable pace, the bank said.

Amplifying the hawkish tone was a report on Friday that over a third of the members of the Governing Council voted for a 0.75% hike. On Thursday, the Bank of England raised rates 50 basis points to 3.5%. Two members of the Monetary Policy Committee voted to keep rates unchanged while one voted for a 75 basis point hike, an unusually wide divergence of views. The market focused on the two no-change votes as a sign that rates are nearing their peak. The Swiss National Bank raised its policy rate 0.5% to 1% on Thursday, while Norway’s Norges Bank hiked 0.25% to 2.75%.



Economic activity in China was weaker than expected in November as industrial production, retail sales, and fixed asset investment fell short of forecasts.

At the conclusion of this past week’s Central Economic Work Conference, China’s leaders vowed to provide more monetary and fiscal stimulus for private businesses as the government shifts its focus from controlling COVID to boosting growth. The group said it would seek to optimise COVID control measures and better coordinate them with economic development while making a recovery of consumption a top priority while stabilising, jobs, growth, and prices. Officials said they will ensure stable growth and meet the “reasonable needs” of the housing sector while reiterating that housing is for living, not speculation.



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