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Fed warning turbocharges dollar, sinks equities


Fed’s second-in-command warns of “stronger action” to cool inflation

Dollar marches higher, stock markets drop, but gold stays rangebound

Cable tracks equities lower, FOMC minutes coming up next

Fed turbulence

The Federal Reserve injected a fresh dose of volatility into financial markets yesterday, after its second-in-command warned of aggressive policy action to rein in inflationary forces. Lael Brainard, who is waiting Senate confirmation to become Vice Chair and typically errs on the side of caution, put investors on red alert by signaling rapid-fire rate increases and a swift reduction of the Fed’s gigantic balance sheet.

She said inflation is far too high and could heat up further, but also highlighted the downside risks to the economy that the bond market has telegraphed lately. The takeaway was that while the Fed won’t hesitate to tighten policy to prevent the economy from overheating, it will also ‘roll with the punches’ and try to avoid causing a recession.

Reading between the lines, Brainard’s remarks suggest the Fed will back off at the first sign of trouble in the economy and perhaps pause its rate hike cycle, yet market participants didn’t interpret it this way. Instead, traders placed more emphasis on the signals for forceful tightening, which sent Treasury yields and the dollar flying in the aftermath.

Dollar roars, euro wallows, equities sink

With the path for US interest rates being recalibrated higher, the dollar continues to reign supreme in the FX arena. Reinforcing this trend is the weakness in the euro, which is stuck in the doldrums as traders remain reluctant to price a similar path for the ECB while the outlook for European growth is so grim.

The European Commission proposed a ban on imports of Russian coal yesterday along with export bans in sectors including semiconductors and quantum computers - the latest in a series of moves to tighten the economic noose around Moscow. Along with fading hopes for a peace deal in Ukraine and a dramatic slowdown in China according to the latest services PMI, the bad news for the euro keeps rolling in.

In the equity complex, fears of an aggressive Fed saw Wall Street close with heavy losses, pulled down by growth and tech shares that are highly sensitive to rising rates. The tech-jammed Nasdaq lost almost 2.3% as the prospect of the Fed reducing its balance sheet at a rapid clip cast a long shadow over the riskiest corners of the market, where valuations have corrected from last year but are not ‘cheap’ by any means.

Cable retreats, gold doesn’t care

Meanwhile, sterling/dollar mirrored the reversal in equity markets yesterday, essentially trading as a proxy for risk appetite. That said, the pound comfortably outperformed the euro and the yen as the rate path for the Bank of England was also adjusted higher, amid spillovers from the Fed.

With real yields powering higher and the dollar slicing through its competitors, it is quite surprising that gold prices have stood their ground. Bullion escaped with very mild injuries considering the storm in bonds, with buyers defending the $1915 region like a stronghold. The Fed repricing has not inflicted any serious damage on gold so far, although the real test will come once there’s a ceasefire in Ukraine and haven demand cools off.

As for today, the main event will be the minutes of the latest FOMC meeting at 18:00 GMT. Markets are currently pricing in another nine quarter-point rate increases for this year, so the spotlight will likely fall on any details around the balance sheet reduction process.

Source: https://www.xm.com/research/analysis/marketComment/xm/daily-market-comment-fed-warning-turbocharges-dollar-sinks-equities-158187
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