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Global Markets to 18 June 2021

The Fed makes an announcement

… and turmoil ensues

The financial markets reacted less than positively to this week’s announcement that the Federal Reserve Bank has considerably raised its expectations for inflation this year. And that wasn’t the only surprise from the Fed: it also altered its time horizon for interest-rate tightening.

While the Federal Open Market Committee (FOMC) kept its benchmark interest rate close to zero, central bank officials did signal – in its so-called “dot-plot” forecast – that there could be two rate hikes in 2023. However, Fed Chair Jerome Powell warned market pundits against reading too much into dot-plot forecasts, indicating that projections need to be taken with a “big grain of salt”.

Market professionals and global investors have been speculating about when the Federal Reserve Bank might begin to cut back on its bond-buying programme. Introduced several years ago, it helped prop up the US economy in the wake of the financial crisis and has played a key role throughout the current pandemic.

According to Chairman Powell , the central bank has been monitoring economic data carefully, and has not decided when to start scaling down or ending its monthly bond purchase programme. “You can think of this meeting that we had as the ‘talking about talking about’ meeting,” said Powell – a nod to a statement he made a year ago about the Fed not “thinking about thinking about raising rates.” “I now suggest that we retire that term”, he went on to say, “which has served its purpose.”

These comments created a measure of turmoil in the markets: the Dow Jones Industrial Average Index posted its worst weekly loss since October, while the S&P 500 and the Nasdaq Composite indices uniformly drifted back. Unfortunately, this weakness on Wall Street had repercussions across other global markets around the world.

To complicate matters further, St. Louis Federal Reserve President Jim Bullard told CNBC that the Fed was tilting towards a more hawkish stance, and that the first rate increase would likely be in 2022, rather than 2023. Fed officials also hiked their outlook for US GDP growth this year up from 6.5% to a median of 7%.

The Treasury yield curve flattens out

… will interest rates be raised sooner rather than later?

The equity market decline and reaction to these statements caused an acute reaction from the US bond market with a flattening out of the so-called Treasury yield curve. This is when yields at the shorter end of the market – such as the two-year note – rise, while longer-duration yields – such as the 10-year Treasury – decline. The retreat in long-dated bond yields tends to reflect less optimism about economic growth, while the jump in short-end yields suggests that the Fed is likely to raise rates sooner rather than later.

Elsewhere, pockets of the equity market that had been sensitive to the economic rebound led the sell-off. Energy, industrials, materials and financials were the sectors that retreated the most last week. Or to put it another way, those cyclical sectors that have been this year’s market leaders thus far.

Commodities find themselves under pressure

… while the US dollar rallies

Commodity prices have also been under some pressure: China’s state council has intensified its crackdown on commodity speculators, dampening down recent price gains. And expectations that interest rates might rise sooner than the FX market was expecting pushed the US dollar up against its peer group of leading global currencies: it recorded its biggest jump since September.

This hit a wide range of commodity prices – everything from copper, gold and platinum to timber and corn. The result was a volatile week for precious, base and agricultural commodities. However, over the longer term – as the energy transition becomes more and more established – specific metals (such as nickel, copper, lithium and cobalt) should remain in high demand with prices reflecting their importance.

While last week’s skirmish in the financial markets can be attributed to the Federal Reserve Bank’s two-day meeting (during which higher inflation, the inevitable rise in interest rates and the withdrawal of central bank support were all discussed and debated), it is not surprising that the financial markets reacted in the way that they did – particularly with the markets continuing their upward momentum since the start of the year.

Has anything really changed yet?

… keeping inflation under control is the primary concern

But a closer read of the official FOMC statement reveals that in actual fact, nothing has changed yet. The US$120 billion-per-month quantitative easing asset-purchasing programme remains unchanged, interest rates are still on hold – and indeed will remain lower for longer – and the government is continuing to borrow vast sums at ultra-low rates.

At the same time, there is a consensus between Fed Chair Jerome Powell and US Treasury Secretary Janet Yellen that the US economy should be allowed to “run hot” for a while since inflation will eventually subside. That said, they still want the inflation rate to hover at just above the 2% mark.

Chairman Powell is keen to avoid the infamous “Taper Tantrum” of 2013 and the flash crash that was triggered during Ben Bernanke’s tenure as Fed Chair. To this end, he intends to be as clear as possible about the Fed’s expectations in order to avoid a rerun of that event.

His focus is on getting more Americans back to work and strengthening the US economy before raising interest rates. Tackling inflation over the short term, however, is not his primary concern.

Good times for equities

… any hikes will pay off over the longer term

Also, with the first tap on the brakes (in the form of a rate hike) likely to be in 2023 (or possibly earlier), global investors can take comfort in knowing that historically, periods leading up to any interest rate hikes have been highly favourable for equities. Global investors should therefore see these pullbacks as a good time to buy excellent businesses – particularly those that will be able to leverage the benefits of our changing world.

Remember: having courage to invest in quality companies in times of a crisis – or during a pullback in the financial markets – will eventually pay off over the longer term.

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