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Dissecting the Fed’s dovish surprise

Macro 3 minutes to read
APAC Research

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.

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