US Close: Markets embrace lengthy Balance Sheet runoff debate, Fed readies March hike

US stocks went on a rollercoaster ride after Fed Chair Powell’s testimony signaled that the Fed “in all likelihood” will be normalizing policy, while allowing the balance-sheet runoff later this year. The Fed sees inflation lasting till mid-2022 and that is probably when they will let the balance sheet decline.

Wall Street now has a better understanding on how the Fed will normalize policy and with the balance runoff likely taking up to four meetings. After Powell’s testimony, some investors feel they got the all-clear signal to buy the dip.  The Fed’s window for tightening is complicated given inflation could finally peak during the summer and since they may not want to look political and be too aggressive removing accommodation so close to the midterm elections.

Investors are still very optimistic about three key things: Household and corporate balance sheets remain very healthy, the upcoming earnings season should be strong, and the economy will still see above trend growth even if the Fed raises rates three times and begins the balance sheet runoff in the summer.

Fed

The opening act to Fed Chair Powell’s confirmation hearing for a second term had a couple hawks, Bostic and Mester both lay the foundation for a March liftoff, while George supported an earlier balance sheet runoff.

Early this morning, Fed’s Bostic told Bloomberg, “We are ready to act to make sure that inflation does not run away from us.” He added that they “should be comfortable and looking to reduce the balance sheet fairly soon after we do our interest-rate liftoff”.

Fed’s George said, “My own preference would be to opt for running down the balance sheet earlier rather than later as we plot a path for removing monetary accommodation.”

That was a very hawkish opening act that should support the idea rates liftoff in March and the balance sheet reduction starts in June.

Powell

Fed Chair Powell’s testimony started with addressing inflation.  He reminded financial markets that supply side constraints have been very durable and persistent, highlighting the number of ships in anchor are at record levels. He explained why they were wrong about inflation being transitory, noting that the situation is unprecedented.

Powell believes the Fed will take steps towards normalizing policy this year.  Wall Street knows rate hikes are coming and expectations are now up to 85% for a March rate hike.

Regarding the labor market, Powell stated, “what we have is a labor supply problem.” The Fed can check off the maximum employment box and now just focus on inflation.

Powell noted that a decision on balance sheet reduction could take anywhere from two to four meetings, which suggests the June meeting will become the base case for many traders.

Overall, Powell was not overly hawkish as he paved the way for a lengthy debate over balance sheet reduction, with his normalization comments taking away some of the importance over tomorrow’s hot inflation report.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Ed Moya

Ed Moya

Senior Market Analyst, The Americas at OANDA
With more than 20 years’ trading experience, Ed Moya is a senior market analyst with OANDA, producing up-to-the-minute intermarket analysis, coverage of geopolitical events, central bank policies and market reaction to corporate news. His particular expertise lies across a wide range of asset classes including FX, commodities, fixed income, stocks and cryptocurrencies. Over the course of his career, Ed has worked with some of the leading forex brokerages, research teams and news departments on Wall Street including Global Forex Trading, FX Solutions and Trading Advantage. Most recently he worked with TradeTheNews.com, where he provided market analysis on economic data and corporate news. Based in New York, Ed is a regular guest on several major financial television networks including CNBC, Bloomberg TV, Yahoo! Finance Live, Fox Business and Sky TV. His views are trusted by the world’s most renowned global newswires including Reuters, Bloomberg and the Associated Press, and he is regularly quoted in leading publications such as MSN, MarketWatch, Forbes, Breitbart, The New York Times and The Wall Street Journal. Ed holds a BA in Economics from Rutgers University.
Ed Moya