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Fed rate decision kicks off central bank bonanza


Fed set to raise rates by 25bps but what tone will Powell strike?

Dollar remains on the back foot, stocks resume euphoric rally

Meta reports earnings, ECB and BoE decisions awaited tomorrow

Fed balancing act

All eyes will be on the FOMC rate decision today. Investors expect the Fed to wind down the pace of rate increases by rolling out a 25bps hike, which is already fully baked into market pricing. As such, the market reaction will depend mostly on Chairman Powell’s economic commentary.

It will be a tough balancing act for the Fed chief. Inflationary pressures are finally moderating and leading indicators point to an economic slowdown ahead, but the labor market is still exceptionally tight and financial conditions have loosened to a worrying extent, generating the risk that inflation returns for a second round.

The Fed won’t feel comfortable that it has thoroughly defeated inflation until it sees some real damage in the labor market, which hasn’t shown up yet. Therefore, there’s no incentive to ‘speak softly’ today, as that could invite further loosening in financial conditions that prolongs this process.

Instead, Powell could stress how strong the labor market is and that inflation remains uncomfortably high, pushing back against market pricing for rate cuts later this year. Investors are not positioned for such a resolute message, judging by the latest moves.

Stock markets are partying, the dollar is soft, and implied volatility is extremely low, so there doesn't seem to be any real concern that Powell will beat the hawkish drums. But that could be a mistake.

Is the euphoria justified?

A sense of euphoria has engulfed financial markets this year. The classic narrative is that global economic fortunes have brightened - the Fed is near the end of its tightening cycle, Europe might dodge an energy-driven recession, and China’s economic reopening will help lubricate demand.

In reality, this excitement likely reflects a massive liquidity dump, which has countered the impact of the Fed’s balance sheet reduction process. Even though the Fed continues to drain liquidity out of the system through quantitative tightening, this effect has been more than offset by reductions in the reverse repo facility and the Treasury depleting its cash balance lately.

Net liquidity was added back into US markets this year, explaining the sensational advances in stocks and the dollar’s inability to sustain a rally. The proof is in the pudding, as the best performing shares this year are unprofitable, low quality, and heavily shorted companies that got smoked last year. These are assets that live and die off liquidity flows, similar to other recent star performers such as altcoins.

When liquidity is abundant, there’s a tendency for stocks to disregard bad news and for the dollar to be fragile, but this is likely a temporary phenomenon. It could reverse once a debt ceiling deal is reached in Congress and the Treasury begins to rebuild its cash balance, which elevates the importance of today’s meeting between President Biden and Republican House Speaker McCarthy on this subject.

From a risk-reward perspective, it’s tough to be optimistic on equities when the S&P 500 is trading at 18 times forward earnings, in a macro environment where corporate profit growth is rolling over.

US data, earnings, and central banks

Ahead of the Fed meeting today, there are several important data releases, including the latest batch of Eurozone inflation numbers, as well as the ADP jobs report and the ISM manufacturing PMI from the United States.

On the earnings front, social media juggernaut Meta Platforms will release its quarterly results after Wall Street’s closing bell. Beyond that, traders will turn their gaze to the European Central Bank and the Bank of England, both of which will announce their rate decisions tomorrow.

Source: https://www.xm.com/research/analysis/marketComment/xm/daily-market-comment-fed-decision-kicks-off-central-bank-bonanza-2-173820
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