Powell confirmed the Fed prefers to remain long optionality, hawkish and data dependent. This is a regime shift from the era of the policy put and creates a more volatile market and interest rate environment for 2022 where the skew of risks for US rates is higher.
Chair Powell was re-nominated in November, and since that point the Fed reaction function has been hawkish. This really began with his first public testimony to Congress in early December. At that time, we noted that “Inflation is now a political issue, and it is logical that Chair Powell’s nomination over Lael Brainard comes with a mandate to ensure that price stability is given appropriate weight in policymaking…and the fact that they have shifted so soon after the taper announcement is indicative of a more responsive and hawkish Fed”.
This view was confirmed with Chair Powell's Q&A last week following the January FOMC. In summary
· He explicitly stated that this cycle may be different from other cycles, noting that the economy and labor market are very strong, and that these differences vs other periods “are likely to have important implications for the appropriate pace of policy adjustment”.
· This backdrop requires the Fed to be “humble” and “nimble” in its policy response.
· He did not push back against current market pricing, rather he validated it, saying the Fed had been successful in its communication.
· He pushed back on the idea that QT can operate to reduce the necessity of hikes.
Powell left little room for misinterpretation of his comments. Right now, the Fed is clearly worried it’s behind the curve and wants to retain the option to respond as forcefully as required to ensure that the price stability part of their mandate is fulfilled. Supply side pressures have not eased, inflation has broadened, and therefore the only way to deliver lower inflation is by cooling demand, which means tightening financial conditions.
In effect, this Fed wants to be long optionality, not short a policy put to the market. The dominant variable that will determine the Fed policy pathway is not the stability of equity markets, it is the path of inflation over the next 3 quarters. If inflation remains high (even if it eases somewhat from these high levels), this Fed will continue to raise rates, and this may come in 50 bp increments if the inflation outlook requires.
This confirms the significant shift that began in Q4 2021. This Fed has a hawkish reaction function, is data dependent, and is engaged in the opposite of forward guidance by retaining as much optionality to respond to incoming data as possible (supporting this point is that it has signaled QT and provided no details).
This policy stance is clearly volatility accretive for rates markets. As the Fed noted in a 2020 working paper, “forward guidance lowered market uncertainty about rates”. This, combined with the Fed's data dependency, the elevated level of macroeconomic data volatility, and difficulty in forecasting in the post-COVID world, means the range of outcomes for short-end US rates over the next 12-18 months is wide but skewed to the upside. However, for the long end, the market continues to flatten curves, implicitly signaling that the Fed will eventually get ahead of the curve too far and tighten policy in a way that reduces long term growth (the higher and steeper scenario we outlined in our note Jan 13). If this continues, it will be a key component of a bullish stance on long-end EM fixed income this year.
Overall, this is a more volatile global environment in aggregate, but one which is extremely interesting, as it is a regime shift from a prevailing macro-political environment, which was in place for most of the last decade. This environment continues to argue for a portfolio which is relatively beta neutral, but increasingly one in which a bearish trading stance may pay dividends in US equities (selling sharp intra trend rallies) and where the floor for US rate hikes this year is 4 hikes. Our portfolio reflects this: we are paid rates in the 2y-5y sector in the US and Poland, we are tactically long USDs vs EMFX, and have our equity views expressed in a beta neutral structure in Europe and Brazil.
COVID Pandemic
Global COVID cases rose marginally by +2.5% last week, with cases rising in Asia, Europe, CEEMEA, Latin America, and falling in the United States. In China, cases fell again last week to just 410 cases, nearly 75% below the recent highs seen in early January. Elsewhere in Asia, cases fell in India, where the recent Omicron wave appears to have peaked. In CEEMEA, cases remained low in South Africa, while rising to new record highs in Russia, Turkey, and Poland. Finally, Latin American cases hit new highs in Brazil and Chile, while falling in Argentina and Chile.
In Europe, cases rose again last week to record highs, with cases continuing to rise across Central and Eastern Europe, while falling in Western European countries such as the UK, Spain, and France. In the US, COVID cases fell sharply last week, with positivity rates also falling. The leading wastewater and Google trends data we track continues to point to a further decline in the US Omicron wave.
Data from the UK shows that the combination of high levels of vaccination and lower Omicron severity has now reduced COVID case fatality rates to levels approaching the seasonal flu. As evidence of lower-case fatality rates continues to grow, policymakers are increasingly shifting away from the restrictions that were commonplace over the last two years. In Denmark, where cases remain at all-time highs, policymakers are set to remove almost all COVID restrictions on Tuesday. Denmark’s Prime Minister Mette Frederiksen announced that thanks to the vaccine “superweapon” COVID-19 is no longer “threatening for society”, with the end of COVID restrictions set to help bring back “life as we knew it before COVID”. The pivot in policymakers’ response function is also seen in Emerging Markets. For instance, in Thailand, which last summer took a zero-tolerance approach, policymakers recently outlined plans to start treating COVID like influenza in the next six to 12 months.
Calvion's View: Despite near-term headwinds from elevated Omicron waves, we are constructive on the medium-term COVID outlook, with elevated immunity levels (from vaccines and infection), lower Omicron severity, increased antiviral treatment availability, and an increasing laissez-faire policy response, creating a strong set-up for further services recovery in the upcoming quarters.