This past week has brought about additional concerns related to inflation. Both the CPI and PPI indices performed higher than expected, causing the market to slightly decrease its valuation chances for a June interest rate cut, although it still believes in it. This coming Wednesday, the Fed will likely leave current parameters unchanged. It will discuss how long QT should last and updated forecasts from the FOMC will be published.
The latest inflation data has created some confusion. Although everyone knew that prices would be raised in the first half of the year, the market was quietly hoping that this scenario would not come true. The core consumer price index is still slightly lower than the levels we observed in previous months, and it stands at 3.8 percent. The PPI index, which usually causes much less excitement, this time has been surprisingly high, causing more market volatility rather than the Tuesday CPI reading.
The “last mile” of battling inflation seems to be at least rough. The Fed will likely maintain its precautionary approach and will refer to recent publications during the press conference. The exact date of the first rate cut will largely depend on the development of inflation. If the recent trend towards slightly higher indices is confirmed, the June rate cut may be slightly delayed. The market would be forced to modify its valuation path, which would certainly strengthen the U.S dollar and cause an increase in US bond yields. It is conceivable that for the heavily purchased stock market, this would be a signal for perhaps a larger correction. The pace of growth seen in recent weeks is not sustainable in the long run. Is profit taking lurking around the corner?
After the meeting, the Fed will publish updated forecasts. I assume that the “dot plot” will still predict three rate cuts in 2024, as in the last update from December. If a “hawkish” change (two cuts) were to occur here, the market reaction would be even stronger.
The Fed has already announced that it will begin intense discussions at its March meeting on how to proceed with balance sheet normalization (“quantitative tightening”, QT). So far, the Fed’s securities portfolio has been reduced by over $1.4 trillion, a decline of 17 percent. The target value of the balance sheet will be particularly discussed. Over the past six months, the Fed has reduced its securities assets by an average of about $75 billion per month. If this process continues at a similar pace and affects “reverse repo” transactions, the excess liquidity will be reduced over the next few months. The Federal Reserve should then begin to gradually withdraw from QT. Next week’s meeting may provide preliminary indications of how exactly the Fed envisions this process.
– Łukasz Zembik Oanda TMS Brokers
