Currently, do the markets want the Fed to be more proactive in adjusting policy? Or do they want the Fed to continue to maintain a dovish stance?
At the moment, there seems to be growing support for the Fed to adjust its policy aggressively. There is evidence that the market seems to want the Fed to become more hawkish. After the release of the Fed minutes early Thursday morning, U.S. bond yields moved slightly higher, but U.S. stocks were unmoved. This is a sign that the market increasingly wants the Fed to start discussing tightening policy.
Traders believe the Fed is making a mistake and sticking to zero interest rates exacerbates the risk of a falling dollar
A few months ago, traders began to worry that the U.S. economy is recovering too quickly, leading to early tightening of policy by the Fed, and expect the Fed to draw down debt at the end of this year as well as raise interest rates early next year.
Concise Capital (Concise Capital) Adrian Miller (Concise Capital) said.
“Many traders want the Fed to be more proactive in adjusting its policy, and hope that the Fed will begin to discuss changing its stance on debt tapering and interest rate hikes. That’s bearish for stocks in the short term, but good news in the long term.”
There is now growing concern that the Fed will not change its policy ahead of time, and the last thing they want is for the Fed to come in and adjust policy after things have gotten serious.
Earlier, European Central Bank officials had begun planning to cut the size of asset purchases, in which case Mohamed A. El-Erian, chief economic adviser at Allianz, said he was concerned about the Fed’s delayed action. On Thursday, he wrote in a report.
“Judging from current market behavior, the recent asset sell-off indicates a growing fear of a policy failure by the Fed. After all, the last thing the economy and markets want is for the Fed to passively tighten policy.”
Marc Chandler, chief market strategist at Bannockburn Global Forex, also said that the rise in the bond market’s inflation expectations indicator, the 5-year and 10-year breakeven inflation rates, earlier this week reflected the view of traders that “the Fed is making a policy mistake “. As long as policymakers don’t “let off the gas,” the dollar’s trade-weighted exchange rate is likely to hit a new low in more than six years.
The dollar fell to its lowest level since 2018 last year as concerns about rising inflation spread through financial markets, and it dived again on Thursday, extending that downward trend. Rising inflation continues to erode the value of the dollar, only this time it’s also accompanied by ballooning U.S. trade and budget deficits. The Fed’s desire to keep interest rates near zero through the end of 2023 has also deprived the dollar of a boost from rising rates, Chandler said by phone.
“Other central banks acted, such as the Bank of Canada began to cut back on asset purchases, and Norway’s central bank hinted at a rate hike later this year, while some European rates rose 10 to 20 basis points in a short period of time, and against this backdrop, U.S. rates stayed low. This turns the absolute global level of interest rates into a significant drag on the dollar.”
He said the dollar is now following the direction of U.S. Treasury yields, and the market overreacted to the Fed’s April meeting minutes on Wednesday, giving the dollar and U.S. Treasury yields a boost that lasted just one day.
The bond market also reflected that the market may be too eager to latch onto potential Fed policy changes. Demand for long-term Treasury futures was good on Thursday. For now, the winning yield on the $27 billion 20-year Treasury issue at 2.286 percent may provide short-term guidance for U.S. Treasuries.
Chandler said the dollar index should fall from its current level of about 90 to as low as 87 or 88 by the end of June or early July, and the euro, yen and pound should rise against the dollar.
Do not panic about the Fed’s size reduction: the Fed will be the dominant force in the market for many years to come
Investors who are worried that the Fed will contract its bond-buying program may have overlooked one thing: the Fed already holds more than $5 trillion in Treasuries and will be a major force in the coming years.
Minutes from the Federal Open Market Committee (FOMC) meeting in April showed that some officials are willing to discuss tapering bond purchases if the economy continues to improve. U.S. Treasury yields rose on the news.
But bond bulls say the Fed has become an almost inseparable presence in the world’s largest bond market, which means it will remain a crucial support force long after bond purchases have stopped.
To keep markets functioning and market rates down on all fronts, the Fed has bought bonds in a big way, doubling the size of its Treasury holdings since March 2020 and coming close to a quarter of the total in circulation, a higher percentage than it held after the credit crisis in 2008. Matt Nest, global head of income, said.
“The Fed is all set to play an important and comprehensive role in the fixed income market.”
Even if the Fed begins to contract its bond purchases, it is expected to maintain a steady size of holdings by buying new debt as old debt matures, reducing the amount that needs to be sold to the public. Some investors therefore believe that interest rates will not rise too fast or too high, even though U.S. Treasury yields are moving toward about 14-month highs touched in March amid concerns about the risk of an overheated economy. Mike Pugliese, an economist at Wells Fargo Securities, said.
“There will be absolutely no immediate action by the Fed regarding the U.S. bond market. The Fed will continue to hold 20 to 25 percent of U.S. Treasuries, remaining the largest holder until about 2025.”
But he expects the Fed will keep its share steady over the next four years, tapering its bond purchases starting in January 2022 and ending around November.
That backdrop, combined with the fact that the government will cut debt issuance later this year as the economy picks up, has kept U.S. bond yields low despite the sharp acceleration in economic growth and rising consumer prices. J.P. Morgan estimates that net Treasury debt issuance will fall to $1.99 trillion next year, compared with $2.75 trillion this year.
JPMorgan strategists predict that the Fed will buy another $390 billion in 2022 before ending its bond purchases. Meanwhile, Vincent Reinhart, a former Fed official and Mellon chief economist, said.
“Whatever changes are made to the balance sheet, the Fed under Powell is being careful, which is why the slowdown in the asset purchase program will be slow and will never sell securities holdings directly after the end of quantitative easing.”
Peter Yi, head of taxable credit research at Northern Trust Asset Management, sees limited upside for long-term U.S. Treasury yields. He expects the 10-year yield to fluctuate between 1.25% and 1.75% for the rest of the year, and has been buying as yields pick up. He added that rising U.S. inflation will be temporary, Yi said.
“The Fed has its own tools to deal with this situation if it needs to stop a sharp and disorderly rise in 10-year yields.”
Dan Krieter, fixed-income strategist at BMO Capital Markets, believes the Fed will not reduce the size of its balance sheet for several years.
“It’s getting harder and harder for the Fed to pull back from the financial system. At least for the next five years or so, the Fed will not even give a hint of tapering.”
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