Several central banks are meeting this week for their monetary policy decision. Yet, the big event everybody is waiting for comes on Wednesday, when the FOMC meeting will decide to hike interest rates for the first time since before the Covid pandemic. Before commenting on markets and what to expect on Wednesday, I believe it is crucial to consider last week’s events as they provide a critical framework for what might happen next.
A hawkish ECB has changed cards on the table.
The market was expecting the ECB to remain dovish last week amid the uncertainty produced by the war in Ukraine. Investors were confident that the central bank would be more concerned about a slowdown in growth rather than inflation. However, they were wrong. Lagarde's message was clear: monetary policies will fight inflation, but growth will need to be taken care of by fiscal policies. That is a massive change from the ECB's message during the pandemic era, which focused on supporting the bloc’s economy.
If it weren’t enough, the central bank clarified that QE is finishing earlier than previously indicated. The Governing Council will conclude net purchases under the APP during the year's third quarter. The ECB will not be around to pick up the bill for higher defense and energy spending schemes. That implies bond yields will continue to surge despite the war's uncertainties.
Yet, news of a possible EU joint bond issuance to finance energy and defense spending helped limit the widening of European sovereign spreads. Despite such news building the case for a much better EU monetary and fiscal integration, it's critical to remember that such decisions are usually not rushed through. During the Covid pandemic, it took nearly six months for members to agree on the NextGenerationEU package. Therefore, until we don't have information regarding an imminent agreement, support for the periphery can wane quickly, contributing to more short-term spread widening.
The market is preparing for an aggressive FOMC meeting.
Anything is possible during Wednesday's FOMC meeting, given the recent hawkish twist of the ECB. Jerome Powell recently said that he's going to vote for a 25bps rate hike at this meeting, but he doesn't exclude a 50bps rate hike in the future, if necessary.
Today, the market is positioning for a much more aggressive Federal Reserve meeting as inflation expectations continue to soar. Nominal yields are also rising, with the 10-year yields breaking above 2.10% for the first time since July 2019. It seems that the market is preparing for an escalation of the ECB meeting. The Federal Reserve will focus merely on inflation from now on, leaving concerns regarding a slowdown in growth to fiscal policies.
A 25bps rate hike might not be enough if that were the message. Fed officials might want to combine their rate hike with an aggressive dot plot or an announcement surrounding the Fed's balance sheet's runoff (or both). Either way, volatility might increase dramatically. This week, the market lacks the life support provided by purchases under the Fed's QE program, which ended last week.