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The Federal Reserve – Fed – has started the year with a shift in its stance, as seen in its January 26 meeting. Such shift, which could be noticed in the publication of previous minutes, leads towards a more Hawkish stance following December 7% inflation, the highest since June 1982.

 

This new standing point aims at controlling the increase in prices and focuses on two elements: the rise in the federal funds rate and the reduction of the Fed’s bonds holdings, which amount to 5.7 trillion dollars in US Treasury securities and 2.6 in mortgage-backed securities. Regarding the matter, Jerome Powell, chair of the Federal Reserve, has stated that the level of the federal funds rate consistent with maximum employment and price stability has declined relative to its historical average. He added that the situation will require that the rate be raised more frequently.

According to the Federal Open Market Committee -the Fed’s monetary policymaking body, the long-run inflation target for the US will remain at 2%, so this will continue to be the reference value on which the markets should focus.

The markets’ interpretation of the statement is that the fed funds rate, currently between 0 and 0.25%, will probably be raised in the upcoming March meeting and that at least three rises may take place during 2022, taking the rate to 2.25%. Powell’s statement seems to corroborate this reading. (Read the complete Statement of the Meeting)

Chart 1. Own Elaboration

In theory, a scenario of inflation control is based on a contractionary monetary policy to reduce the money supply in the economy through the use of two tools. The first of these tools is the increase in the federal funds rate, which leads commercial banks to raise their interest rates. Obtaining credit, as a consequence, becomes more expensive. Subsequently, the demand for goods and services decreases taking pressure off prices. The second tool is the sale of US Treasury, debt, and mortgaged-back securities that accumulated on its balance sheet due to the Quantitative Easing policy that the Fed has implemented during the past two years. When the Fed sells bonds, it decreases the money supply by removing cash from the economy.

Decisions taken by the Fed will undoubtedly have an impact on the markets. The impact and background forces for fixed and variable-income securities are analyzed below.

 

Fixed-income Market

Central Banks’ policies have quite an impact on the fixed-income market, where bonds are affected by investors’ viewpoints on rates and inflation expectations. Chart 2 shows the behavior of the 10-Year US Treasury yield. It is worth recalling at this point that bond prices and yields move in opposite directions.

 

Chart 2. Own Elaboration. Data: Bloomberg

Examining last year’s behavior, the publication of the Fed’s meeting minutes triggered a sell-off of US 10-Year Treasuries and government-issued bonds from other countries. The yield went from 1.35 to over 1.80%, which implies a price drop.

The reason? The main cause of this event was not the rise in the rate, but the increase in inflation expectations. It was the acceptance of the fact that inflation was a problem that had to be addressed. Higher inflation expectations discourage long-term bonds holding, given that when prices go up, money loses value over time. Discount rates escalate, and there is a depreciation of their current value.

 

Variable-income Market

In this case, the analysis of the impact is less straightforward. The publication of the Fed’s minutes overlapped with the publication of income statements from many companies, including some technology firms. However, the drop of the S&P500, of between 4,633 and 4,327 units, concurs with the effect on bonds of the rate increase.

Chart 2. Own Elaboration. Data: Bloomberg

Regarding the stock market, the actions taken by the Fed in terms of rates and securities mark the end of a couple of years characterized by increased liquidity. The implementation of expansionary monetary policy was aimed at promoting economic growth in the context of the pandemic. In this situation, investors consider prices upward trend, and risk perception linked to those assets.

As mentioned in previous columns, the Fed’s policymaking transcends the US markets and has a global effect on stocks, bonds, and exchange rates. Gaining a full understanding of the Fed’s stance, language and tools became indispensable to predict how investors react to its decisions.

 

This report was written only as content by Gandini Análisis for SupraBrokers. It shall in no case be considered an investment recommendation.  

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