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Macro Insights: Bumpy inflation or bumpy Powell?
Summary: Powell’s testimony to the Congress started with a hawkish message. Market is now tilting in favor of a 50bps Fed rate hike this month and a terminal rate expectation of over 5.6%. Friday’s jobs data and next Tuesday’s CPI print will be key tests for whether a 50bps March rate hike gets cemented, but what is clear is that Powell’s shift to disinflation narrative in February was premature. Risk assets may remain under pressure if data stays hot, while the path of least resistance for the dollar is higher.
Powell’s credibility at risk
The semi-annual testimony from Fed Chair Powell was indeed hawkish, despite a political stage being set up. Instead of being relieved by incoming growth indicators, Powell still seemed worried about inflation despite his relaxed stance at the February FOMC meeting where he started the chatter on disinflation. Powell increased the prospect of a return to larger rate hikes, saying, “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes”.
The resulting increase in the probability of a 50bps rate hike at the March 22 FOMC meeting is shown in the chart below. He also added that with the latest economic data having “come in stronger than expected”, it “suggests that the ultimate level of interest rates is likely to be higher than previously anticipated”. This change in stance, after just one month of strong data, is proof that Powell took comfort in disinflation prematurely.
High stakes for the next set of data
The reaction to Powell’s testimony remains at risk of reversal, unless upcoming data supports it. Friday’s jobs report or next Tuesday inflation print will be key to watch to make or break the expectations of a 50bps rate hike in March. Hotter-than-expected prints can also bring the terminal rate pricing closer to the 6% mark, making the Fed’s lag to the market ugly. Moreover, shifting to a 50bps rate hike after just one go at the 25bps rate hike pace will be an embarrassment for Fed and its models.
Bloomberg consensus expectations point to another strong jobs report after the blowout report of January. Headline jobs are expected to come in again at 200k+, but risk of disappointment remains given the scope of correction from +517k in January. The unemployment rate is expected to remain unchanged at 3.4%, while wage growth is projected to accelerate. Most early indicators such as the business surveys from S&P pointed to an acceleration in hiring, while applications for unemployment benefits remained historically low. Overall message, despite a potentially softer headline print, is likely to be that US labor market is still tight and there are millions of open positions even as layoffs continue to ramp up in some of the sectors.
Risky assets to remain under pressure
Along with a higher probability of a 50bps rate hike in March, the shift in tone from Powell has also seen the terminal rate pricing for the Fed Funds target rate to rise to 5.65% from 4.9% at the end of 2022 and the 5-5.25% hinted in the December dot plot. A brutal sell off in Treasuries followed the remarks, with the yield on 2-year Treasuries rising over 12bps to over 5% for the first time since July 2007 and rising further to 5.05% in Asian session. The longer end of the curve, however, recovered from their intraday lows with the 10-year yield closing only 1bp cheaper at 3.96% and the 30-year yield 2bps richer at 3.87%. This made the 2-10-year yield curve flatten to -105bps, the deepest inversion since September 1981.
But something seems amiss with the higher-for-longer message not moving the 10-year yields. Either the 10-year yield will need to move higher or the 2-year will need to revert back lower to give a consistent message. This means higher interest rate volatility will remain in the cards, also suggesting higher risk premium for equities. This keeps diversification beyond US equities in favor. We expect European and Asian equities to outperform this year. China also appears poised for an upswing in growth as economic momentum picks up, but the recovery can remain bumpy in light of regulatory and geopolitical risks.
Dollar’s path of least resistance is higher
The US dollar is now back at its YTD high with potential for another leg higher after a minor correction. For the DXY index, key levels to watch are the 200DMA and 76.4% retracement at 106.45. The dollar is benefitting from a host of tailwinds including:
- elevated short-end rates
- a restrained rise in long-end yields suggesting a bid for safety
- China’s lower-than-expected growth target for 2023
- dovish turns from some central banks such as RBA, and BOC likely to pause this week
- excessive pricing in for ECB and BOE rates remaining at risk of a correction
Even if the Fed was to go for a 25bps rate hike again at the March meeting, there is enough reason to believe that that the dot plot will shift higher. That will also be sufficient for the USD to stick to its current range.