What a more hawkish Fed could mean for gold, dollar, stock market?
15:52, 6 January 2022
The December minutes from the US Federal Open Market Committee (FOMC) indicated a more aggressive tone by Federal Reserve board members, who highlighted the need to tighten monetary policy quicker to tackle high and persistent inflation.
The immediate market responses following the release of the minutes were marked by a return of volatility on riskier assets, with Nasdaq’s tech stocks plunging sharply, gold giving up prior gains and the US dollar strengthening as Treasury yields soared.
Investors have anticipated their expectations of a first interest-rate hike, with Fed Futures currently indicating a 70% likelihood of an uplift as early as March 2022, according to the latest CME Group’s FedWatch Tool.
With the Fed heading to a more hawkish stance in the coming months, what might be the consequences for major asset classes?
5 key takeaways from FOMC minutes
- Higher inflation, tighter labour market. The current economic outlook was deemed more optimistic than it was at the beginning of the last normalisation phase, with higher inflation and a tighter labour market, which many participants believe would fast approach to maximum employment.
- Omicron poses upside risks on inflation. Discussions on the inflation outlook were focussed on increasing housing prices and rents, wage increases caused by labour shortages, and longer-lasting global supply-side frictions, which might be worsened by the Omicron variant’s spread.
- Tapering will cease in March 2022. Members decided to slow the monthly rate of net asset purchases by $20bn for Treasury securities and $10bn for agency mortgage-backed securities, meaning that the Federal Reserve’s securities purchases will halt by mid-March.
- Faster pace of rate hikes. Participants signalled that current economic circumstances may demand a sooner or faster rate hike than originally anticipated.
- Fed’s balance sheet reduction. Members of the board noted the Federal Reserve’s balance sheet was much higher than it was at the conclusion of the last asset purchase programme in 2014, both in absolute terms and relative to gross domestic product (GDP). Therefore, many participants agreed it would be appropriate to lower the size of the Federal Reserve’s balance sheet after the start of rate hikes.
The Fed’s balance sheet rose to 42% of US GDP at the start of 2022, the highest level ever recorded since World War II.
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Federal Reserve's balance sheet size as % of US GDP – Credit: TradingviewThe real yield is what matters
The FOMC’s hawkish tone in the December minutes fuelled the jump in US Treasury yields, with the 2-year yield reaching 0.80%, the highest level since early March 2020, and the 10-year yield hitting 1.74%, close to 2021 highs.
The steep increase in nominal Treasury yields has led to a rise in US real rates (the yields on inflation-protected Treasury securities or TIPS). Following the publication of the FOMC minutes, US 10-year real yields increased by approximately 10 basis points to -0.8%, the highest level since June 2021, as a result of a spike in the 10-year Treasury yield and a decline in the 10-year breakeven rate, a gauge of investors’ long-term inflation expectations.
US real rates are a key barometer for a broad range of asset classes, since their rise makes riskier assets less attractive in comparison to risk-free assets. A more hawkish Federal Reserve has historically driven real yields higher, as happened in the previous episode of monetary tightening (Taper Tantrum) in 2013.
US 10-year real yields (pane above); US 10-year yields and 10-year breakeven rates (pane below) – Credit: TradingviewWhat a hawkish Fed could mean for gold?
Gold has historically provided protection against inflationary threats, but its inflation-hedge status might be strongly tested in a market environment in which the Fed decides to adopt a more restrictive monetary policy.
It is no surprise that gold has the one of strongest inverse correlation with US real rates among all asset classes. Historically, as real rates rise, non-yielding assets such as gold have suffered, as investors perceive cash and risk-free assets relatively more appealing due to their higher real rewards.
Clearly, the real returns on risk-free assets depend not only on the Fed funds rate but also on the level and expectations of inflation. Therefore, if the Fed struggles to contain inflation while raising interest rates, gold could still attract investor demand for the time being.
Gold (inverted) vs US real yields – Credit: TradingviewWhat a hawkish Fed could mean for forex market?
Except for the Bank of England, which already raised interest rates in December 2021, the US Federal Reserve seems to be moving ahead of other major central banks in the monetary-policy normalisation cycle.
Currently, market participants are setting in prices for three interest rate hikes by the end of 2022, placing in a 70% chance of a first move as early as March 2022, according to the latest CME Group's Fed Watch tool.
A more hawkish than anticipated Federal Reserve would bolster the dollar’s interest rate attractiveness versus low yielding currencies, particularly the euro, Swiss franc and Japanese yen, which are backed by central banks which have not yet signalled the need to move toward a more restrictive monetary policy.
Monetary policy divergences are one of the main factors driving the performance of currency pairs on the forex market. Interest rate differentials on short-term sovereign bonds are a good approach to quantify how two central banks differ on the path of monetary policy.
The widening of the US-Eurozone short-term yield spread reflects the current Fed-ECB policy divergence and has been closely linked with the EUR/USD performance in recent months.
EUR/USD (inverted) vs US-Germany 2-year yield spread – Credit: TradingviewWhat a hawkish Fed could mean for stock market?
The prospects of speedier rate hikes might weigh on stocks that are already pricing in high future earnings growth or have high debt levels on their balance sheets. The former would have reduced future cash flows as a result of higher interest rates necessary to finance required investments for growth, while the latter will see a rise in debt service costs.
It is critical to emphasise that the more gradually the Fed raises interest rates, the more adaptable the stock market will be to new financial conditions. If the Federal Reserve’s rate hike pace exceeds market expectations, this might result in an increase in stock market volatility.
One of the important elements affecting the stock market’s performance will also be the Federal Reserve’s speed of balance sheet reduction. The more quickly the Fed reduces its assets, the higher the risks to a step back of the stock market as a result of less market liquidity.
The Fed’s rapid expansion of its asset during the pandemic was, in fact, one of the primary drivers supporting the rise of the stock market, as can be demonstrated by the strong correlation between Fed’s balance sheet size and the S&P 500 index.
S&P 500 index vs Fed's Balance Sheet size during Covid-19 pandemic – Credit: TradingviewRead more: Great Resignation signals power shift to US labour force
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