Federal Federal Federal

Dissecting the Fed’s dovish surprise

Macro 3 minutes to read
Saxo-Strats
APAC Strategy Team

Summary:  The markets have seen a relief rally with Fed Chair Powell ruling out a 75 basis point rate hike for now. While room for Fed’s hawkish surprises in getting restrained, stretched positioning going into the May meeting and rising expectations of larger moves led to the ‘as expected’ outcome to be perceived as ‘dovish’.


The Federal Reserve delivered its first 50 basis point rate hike in 22 years on May 4, and signaled similar rate increases are on the table for June and July. The balance sheet runoff is slated to begin in June with holdings of Treasuries and mortgage-backed securities (MBS) to start to decline at an initial combined monthly pace of USD 47.5 billion, stepping up over three months to USD 95 billion -  all of which was as expected. What was somewhat surprising was Fed Chair Powell ruling out larger (75 basis point) rate hikes for now – and that constituted as a dovish surprise fueling a relief rally in the markets.

Some key statements from Powell worth highlighting were:

  • the central bank is committed to get inflation under control and won't hesitate to go higher than neutral if need be
  • tightening is not going to be pleasant as rising rates mean borrowing costs and mortgages will be higher
  • Powell also praised former Chair Paul Volcker who had raised rates to 20% in late 70s/early 80s to crush inflation and caused a recession

All of these suggest anything, but dovishness. Fighting inflation remains the Fed’s top priority, and we saw some tentative indications that Powell sees a slightly more risk of a slowdown (or at least, a moderation in activity). That, however, will not come in the way of his fight against inflation.

This explains why he stayed away from the most hawkish stances possible. What made him dovish was the overshooting market expectations over the last few weeks as we approached the May meeting. In contrast, Powell’s tone was more calm, aimed at avoiding any shock waves to the markets on inflation. Also, Powell needs to save his ammunition, as underlying inflationary pressures are unlikely to come down significantly anytime soon and going too fast will mean going way above the neutral rate later and risking a hard landing.

In terms of today’s relief rally, it is worth noting that 5Y US Treasury yields and the US dollar are still at stretched levels, remaining above the levels that prevailed for most of April. So, positioning has a big role to play in today’s market reaction.

Over in emerging markets (EMs), the Reserve Bank of India (RBI) held an unscheduled meeting on May 4 – just hours ahead of the Fed announcement – and voted to increase the repo rate by 40bps, bringing it to 4.40%. Cash reserve ratio was also increased by 50bps, aimed to withdraw INR 870bn of liquidity. Meanwhile, Brazil’s central bank increased policy rates by 100 bps to 12.75% and signaled further tightening ahead. This is a 180 degree turn to its previous plans of ending the tightening cycle in May.

As food inflation, along with energy inflation, starts to bite EMs, we are likely to see more and more EM central banks getting on the tightening bandwagon sooner than expected. Indian 10-year yields rose 28bps to 7.40%, reaching their highest levels since 2019. Something of that nature can still be expected for other EM bonds as well.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank A/S (Headquarters)
Philip Heymans Alle 15
2900
Hellerup
Denmark

Contact Saxo

Select region

International
International

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

This website can be accessed worldwide however the information on the website is related to Saxo Bank A/S and is not specific to any entity of Saxo Bank Group. All clients will directly engage with Saxo Bank A/S and all client agreements will be entered into with Saxo Bank A/S and thus governed by Danish Law.

Apple and the Apple logo are trademarks of Apple Inc, registered in the US and other countries and regions. App Store is a service mark of Apple Inc. Google Play and the Google Play logo are trademarks of Google LLC.