The Federal Reserve raised interest rates by 0.25 percentage points at its February meeting, to 4.5-4.75%, which was in line with most analysts' expectations. The announcement of the decision was followed by a conference call by Jerome Powell, Fed chairman. The market seems to have reacted positively to his speech. Indeed, the S&P 500 Index (US500) rose by 1% yesterday. What did the Fed chief say and how might it still affect the market?
Source: Conotoxia MT5, US500, Daily
What is the Fed looking at? The target is inflation of 2%.
"We can now say I think for the first time that the disinflationary process has started,” he told reporters, adding that he expects U.S. economic growth to be positive this year, even if it falls to a “subdued pace”.” Such words from Powell may be borne out by the CPI inflation readings, which fell from 9.1% to 6.5% in six months. The faster-than-expected fall in inflation may be one factor that would make borrowing costs fall earlier than expected. Nevertheless, Powell made clear the need for further interest rate rises. "We continue to anticipate that further increases will be appropriate to achieve a monetary policy that is sufficiently restrictive to bring inflation back to 2% over time. In addition, we continue the process of significantly reducing the size of our balance sheet." Reducing the size of the Fed's balance sheet means selling assets. This action could have a cooling effect on the market and at the same time have an impact on currency appreciation. The easiest way to envisage this action seems to be to assume that the US dollar is the same asset as, say, equities. When the Fed divests equities at all costs in favour of the currency, the price of the former tends to fall and the price of the currency rises.
Source: FRED, Assets: Total Assets: Total Assets: Wednesday Level
The situation in the US labour market is also an important factor for the Fed. Powell points out that despite the economic slowdown, this sector has remained strong, as evidenced by, among other things, unemployment remaining at a 50-year low. Job cuts, particularly in the new technology sector, do not yet appear to be translating into the broad market, but could be seen as a warning sign.
The final factor that the Fed seems to be paying attention to at the moment is US economic activity. "The U.S. economy slowed significantly last year, with real GDP rising at a below-trend pace of 1 percent. Recent indicators point to modest growth of spending and production this quarter. Consumer spending appears to be expanding at a subdued pace, in part reflecting tighter financial conditions over the past year. Higher interest rates and slower output growth also appear to be weighing on business fixed investment." - Powell said.
Source: FRED, Real Gross Domestic Product
When reading the chart of real GDP, it is important to remember that they are given on an annualised basis. This means that the value is given if this rate of return had been sustained for 4 quarters.
What could we expect?
In the event of interest rate cuts, one of the assets that would start to rise in price first could be bonds. If you look at the iShares 20 Plus Year Treasury Bond ETF (TLT)'s listing for bonds over 20 years, you can see that they are already pricing in future interest rate cuts. Currently, according to the FedWatch Tool which collects forecasts of future interest rate levels, around 40%of analysts assume that we will see the peak of interest rate rises at 5% in September this year.
Source: Conotoxia MT5, TLT, Weekly
Today we will learn the ECB's decision. The analysts' consensus is that interest rates in the euro area would rise by 0.5 percentage points, to 2.5%. Despite Tuesday's lower-than-expected CPI inflation reading, the level is still 8.5%, putting much more pressure on this central bank to raise rates. As a result, the European currency may continue to strengthen against the dollar.
Source: Conotoxia MT5, EURUSD, Daily
Grzegorz Dróżdż, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
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