Vijay Kumar Gaba

 Sitharaman, Powell toss the ball in Das’s court

Wednesday night, the Federal Open Market Committee (FOMC) decided to maintain the status quo on policy rates for the fourth successive review. The Committee reiterated that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward two percent.” The Committee however made it quite clear that any rate hike from the present level is no longer on the table.

In the post-meeting press meeting, Fed Chairman Jerome Powell indicated that FOMC may not consider rate cuts in its next meeting in March 2024. The market is thus expecting a rate cut in May 2024.

In another development, the Union Finance Minister, Ms. Nirmala Sitharaman, presented an interim budget for the fiscal year 2024-25. Two notable features of the interim budget were (i) Nominal GDP growth projection for FY25 at 10.5%, implying a well-controlled inflation environment; and (ii) Fiscal deficit of 5.1% of GDP for FY25BE, implying a strong commitment to fiscal discipline.

In line with the lower fiscal deficit projection, the borrowing program of the government has also been moderated. The finance minister has proposed Rs11.75trn of net borrowing from the market by way of fresh government securities in FY25BE against Rs11.80 borrowed in FY24RE. This shall leave decent scope for private investment.

In her speech, the finance minister also emphasized the supportive environment her government is building for acceleration in private capex to achieve the high growth targets. The minister has provided higher allocation for production-linked incentives (PLI).

With the global rate and monetary policy environment set to become benign in 2H2024; domestic macro (fiscal deficit, inflation, external conditions, etc.) improving and the government holding its side of promise to maintain fiscal discipline despite forthcoming general elections, the ball is now in the court of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) to provide impetus to the economic growth.

The risks to inflation now mostly stem from food (inclement weather) and energy (geopolitical disruptions) which may not have a significant correlation with the policy rates. It would therefore be in order for RBI to guide a lower rate path and increase system liquidity.

The MPC meeting next week therefore will be watched with keen interest. I would not expect any immediate rate cut (though it will be welcome if happens), a clear guidance for lower rates going forward and enhanced system liquidity is what I do expect from MPC. If RBI delivers on these expectations, markets could rally to new highs led by financials and rate-sensitive sectors like auto and real estate.

As widely expected, the Federal Open Market Committee (FOMC) of the US Federal Reserve, unanimously decided to keep the key fund rates at 5.00% - 5.25% for the second consecutive time. The FOMC had last increased the rates in July 2023.

The Committee noted, "Economic activity expanded at a strong pace in the third quarter". It also acknowledged “the tighter financial conditions faced by businesses and households”. Upgrading its outlook for the US economy, Fed Chairman Jerome Powell remarked, “The process of getting inflation sustainably down to 2% has a long way to go”.

After the last meeting in September 2023, the monetary policy statement issued by the FOMC had noted that “credit conditions have tightened” consequent to the eleven consecutive hikes delivered by the Fed. This time, the Committee added “financial” to the credit conditions, noting the rising stress in the financial system as a consequence of rising bond yields.

Caught between the resilient economy and building stress in the financial system, the Federal Reserve seems to have decided to stay on the fringe and let the markets find their equilibrium.

Though, the post-meeting FOMC statement reads, “committee is still determining the extent of additional policy firming” and “The Committee will continue to assess additional information and its implications for monetary policy,” the consensus in the market is leaning towards “a long pause” followed by a series of cuts; assuming the Fed is done with hiking and it will now wait for the market forces to find an equilibrium on prices and growth.

Whitney Watson, co-CIO of fixed income and liquidity solutions at Goldman Sachs Asset Management, reportedly commented it’s likely the Fed will keep its policy unchanged into next year. “There are risks in both directions,” Watson said. “The rise in inflation expectations, owing to higher gas prices, combined with strong economic activity, preserves the prospect of another rate hike. Conversely, a more pronounced economic slowdown caused by the growing impact of higher interest rates might accelerate the timeline for transitioning to rate cuts.”

Post the release of the FOMC statement, the yield on the two-year Treasury, which is more sensitive to Fed policy, fell 12.5 basis points to 4.93%, the lowest level since September 2023. Stocks also rallied with S&P500 and NASDAQ ending the day with over one percent gains.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (the Fed) decided unanimously to keep the benchmark fund rate in the range of 5.25% - 5.5%; pausing one of the sharpest hike cycles in the past four decades. Beginning in March 2022, the Fed has hiked the benchmark rate 11 times to the highest since 2001.

The latest FOMC decision may be influenced by the recent evidence showing that the hikes already implemented are beginning to impact inflation, despite strong economic outcomes. Notwithstanding, its latest decision to pause, 12 out of 19 FOMC members felt that one more rate hike would be needed in 2023 before the current rate hike cycle ends, as inflation is still running above the Fed’s 2% target. The persistent strength in the economy requires caution as inflation might bounce back again.

In particular, FOMC members sounded cautious about the tight labor market, as wage growth has so far accounted for the bulk of price pressures in the service sector,

Higher for longer

Speaking at the post-meeting press conference, Fed Chairman Jerome Powell, cautioned that "Holding the rate doesn't mean we have reached the stance we seek”. The committee projects the median Federal Funds rate at 5.1% in 2024, higher than its June estimate of 4.6%, suggesting that rates will remain higher for longer than earlier projections.

The FOMC members now see a couple of rate cuts in 2024, against four rate cuts projected previously. For 2025, interest rates are expected to drop to 3.9%, well above the 3.4% previously projected, and fall further to 2.9% in 2026.

Economic growth forecast upgrade

Taking cognizance of the persistent strength in the economy, FOMC upgraded its economic growth forecast for 2023 to 2.1% from the previous 1% rate projected in the June 2023 meeting. The growth forecast for 2024 was also raised to 1.5% from the previous 2.1%.

Yields spike, curve inverted

Post the announcement of the FOMC decision, the US bond yields rose to cycle highs. The benchmark 10-year G-Sec yields ended at 4.395%, while the more sensitive 2yr yields were at 5.17%. The US treasury bond yield curve is now sharply inverted, indicating market expectations of much slower growth, if not full-blown recession in the offing.

Equities correct led by big Tech

The US Equities corrected over 1% from their intraday highs, post the FOMC decision. The fall was led by the growth sectors, especially the big technology companies like Alphabet (-3%), and Meta Platforms (-1%) and Apple (-1%).

 I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

·         The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

·         The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

·         The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

·         Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

·         The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

·         The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

·         The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

·         The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·        
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow

 The Monetary Policy Committee (MPC) is currently holding its bi-monthly meeting. This particular MPC meeting is perhaps one of the least discussed by the market participants. There is not much anticipation about the outcome that will be known tomorrow morning. The consensus overwhelmingly believes that RBI will maintain the status quo on rates and monetary policy stance.

A quick reference to a note prepared by the research team of the State Bank of India would be apt to highlight the extent of the lack of excitement amongst market participants over this MPC meet. The SBI team devoted three full pages to verify a humorous US study that correlates the height of Fed chairman to the rate hikes and discovered that incidentally it is true in the case of India also.

Though the market is divided in its expectation about the course of action the Federal Open Market Committee (FOMC) of the Federal Reserve of the US would take in their meeting scheduled on 13-14 June 2023; few expect a 25bps hike by the Fed would have any bearing on the RBI decision making. To that extent RBI policy making effort may have already diverged from the developed market central bankers, particularly the US Federal Reserve.

The reasons for this divergence in the direction of monetary policy are obvious – strong growth data; inflation within tolerance range; stable bonds and currency markets; comfortable liquidity; positive foreign flows; much improved current account; and better than expected corporate performance. Specter of an erratic monsoon is definitely a red flag; but it may influence the timing to begin easing the monetary policy rather than the decision to maintain the status quo. 

I find it interesting to note that economists are not bothered to mention the probability of the MPC to consider accelerated tightening due to heating of economy, especially given the GDP growth has outpaced RBI’s own much above consensus forecast; spike in unsecured personal loans; and sharp rise in real estate prices in most urban and semi urban pockets.

Like market participants, I am not eagerly waiting to hear what the governor Das has to say on the MPC decision tomorrow morning. Nonetheless, I would be keenly watching if the RBI takes some precautionary steps to check unsecured personal loans and credit to the real estate market. I am also not keen to look for a hint of rate cut in the August meeting, though the real rates are now in the territory where these could constrict growth.

 The Federal Open Market Committee (FOMC) of the Federal Reserve of the US announced another 25bps hike, taking its key fed fund rate toa target range of 5.00 to 5.25%. This unanimous decision of the FOMC is the 10^th straight hike in the past twelve months. With this hike, the effective fed fund rate is now highest since the global financial crisis. Besides the hike, the Fed also maintains the plan to shrink the balance sheet each month by $60 billion for Treasuries and $35 billion for mortgage-backed securities.

…claims banking system “strong and resilient”

Noting the concerns in the financial markets, especially those arising from the failure of Signature Bank, Silicon Valley Bank and First Republic Bank, the FOMC emphasized that "The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks."

…reiterates “growth modest”, “job gains robust” and “inflation elevated”

The FOMC noted that recent data suggest that growth has been modest while “job gains have been robust” and inflation is “elevated.” Reiterating its commitment to the 2% inflation target, the Committee cautioned about the further slowdown in economic growth due to tighter credit. FOMC post policy meeting statement read, “tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.” This is very similar to what the FOMC had stated in previous policy statement in March 2023, which had come just after the collapse of Silicon Valley Bank and Signature Bank.

…stops short of saying “pause”

The latest FOMC statement omitted the previous wording ““some additional policy firming” and instead said it “will take into account various factors “in determining the extent to which additional policy firming may be appropriate”. Analysts largely interpreted this change as a signal for pause from the next meeting in June 2023; though no one suggested that any policy easing may be imminent.

The US Federal Reserve Open Market Committee (FOMC) decided to hike the key federal fund rate by 25bps to 4.75% - 5% range. This is the eighth straight hike decision by the FOMC since the Fed started its fight against inflation in March 2022; bringing the rates to highest since September 2007.

Speaking to the press post FOMC meeting, the Fed chairman Jerome Powell, dismissed the speculation about any imminent rate cuts, stating “FOMC participants don't see rate cuts this year, it is not our baseline expectations”.

The post meeting statement of FOMC indicated that the policy may remain sufficiently restrictive though future hikes shall be data dependent. The statement read “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time” and “The Committee will closely monitor incoming information and assess the implications for monetary policy”.

The market participants interpreted the statement to imply that at least one more rate hike of 25bps will be done this year, before the Fed hits a pause button.

Powell emphasized that the Fed is “committed to restoring price stability, and all of the evidence says that the public has confidence that we will do so.” Speaking about the recent banking sector crisis, the chairman assured that “US banking system is sound and resilient” and the Fed is “prepared to use all of its tools to maintain stability.” He however admitted that recent banking turmoil is “likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”

The Fed maintained that the current pace of quantitative tightening (QT) shall continue, though recent emergency measures to mitigate the impact of the banking crisis have resulted in expansion of its balance sheet.

The US equities ended the session with a cut of 1.6%; while US dollar index 9DXY) lost 0.7%.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) unanimously decided to hike the key bank rate by 50bps to 4.25%-4.5% target range, the highest since 2007. From near zero in the beginning of the year, this is perhaps the sharpest rise in rates in one calendar year.

In the customary post meeting press conference, the Fed chairman Jerome Powell emphasized on the commitment to rein inflation. He said, “we still have some ways to go” and “I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way,” indicating that rates will rise in 2023, though not at the same speed as 2022. The Fed chairman reiterated, “It is our judgment today that we are not at a sufficiently restrictive policy stance yet,” adding “We will stay the course until the job is done.”

The Fed Chairman had stated after the November FOMC meeting that the pace of tightening is less significant than the peak and the duration of rates at a high level. The Fed’s latest stance also emphasizes that the markets should brace for “higher for longer”.

The FOMC statement clearly indicated that they are aware that higher rates will impact the economy adversely. The projected unemployment rate for 2023 has been hiked to 4.6% from 3.7% in November 2022, as the economy is forecasted to grow at just 0.5% in 2023, at the same pace as 2022. The Chairman noted, “I wish there were completely painless way to restore price stability. There isn't, and this is the best we can do.”

It would be interesting to see if the Fed can actually deliver a soft landing of the economy as promised, without triggering a deeper recession, while attaining a milder inflation as per the target.

The Fed Chairman welcomed the recent lower inflation prints, but wants more substantial evidence to believe that the inflation is on a sustained downward path. He said, “the inflation data received so far in October and November show a welcome reduction in the pace of price increases, but it will take substantially more evidence to give confidence inflation is on a sustained downward path.” The Fed now expects the personal consumption expenditures price index, currently running at 6% - to cool to 3.1% in the final quarter of next year and to 2.5% by the end of 2024.

Belying the market expectations, the Fed Chairman clearly hinted that the rate hikes will continue in 2023 and the policymakers projected rates now indicate that we may end the next year around 5.1%, slightly higher than the previous projections. The dot plot now indicates a cut of 100bps from 5.1% in 2024.

 The latest policy statement and the aggressive stance of the Fed, is likely to anchor the inflationary expectations while resting the frequent speculations of an imminent “peak” followed by immediate easing of rates.

The equity markets were disappointed as most participants were expecting a “peak” below5% and a cut in 2023 itself. The stock ended lower after a volatile session. The bond markets were however not too bothered and yields ended marginally lower after the Fed statement.

 The minutes of the last meeting of the Federal Open Market Committee (FOMC) of the US Federal Reserve System (Fed), held in November 2022, were released a couple of days ago. The meeting was a joint meeting of the FOMC and the Board of Governors of the Fed, hence the number of participants were much larger than a usual FOMC meeting.

After the release of the minutes, the popular media narrative has been that the Fed officials and most participants are concerned about the likely adverse impact rate increases could have on financial stability and the economy; hence, we could “soon” see the Fed scaling down the pace of rate increases. The markets have obviously drawn a sense of comfort from this narrative and decided to move higher.

The minutes make some points that I found worth noting. From a plain reading of the minutes, I find that the participants were generally—

(a)   Surprised by the resilience of the job market;

(b)   Concerned about the persistence of the inflation and assessed the risk on the upside;

(c)    Comfortable with the broad economic conditions which are presently indicating slower growth but no risk of recession;

(d)   Comfortable with the anchored inflationary expectations;

(e)    Confident that the monetary tightening will reflect on inflation and other economic conditions with a time lag;

(f)    Inclined to keep the monetary policy “restrictive” for long;

(g)    Focused on the final Fed rate that would be adequately restrictive, rather than the rate hiked per meeting; and

(h)   Mindful of the market expectations and behaviour about the monetary policy direction and trajectory.

The media narrative of a slower pace of hikes (50bps in December meeting), seems to be driven by the following five mentions in the FOMC minutes:

1.    The minutes noted that “Most respondents to the Open Market Desk’s surveys viewed a 50 basis point increase in the target range for the federal funds rate at the December meeting as the most likely outcome.”

2.    “A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee’s goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability. The uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation were among the reasons cited regarding why such an assessment was important.”

3.    “A few participants commented that slowing the pace of increase could reduce the risk of instability in the financial system.”

4.    “Some participants observed that there had been an increase in the risk that the cumulative policy restraint would exceed what was required to bring inflation back to 2 percent. Several participants commented that continued rapid policy tightening increased the risk of instability or dislocations in the financial system.”

5.    “There was wide agreement that heightened uncertainty regarding the outlooks for both inflation and real activity underscored the importance of taking into account the cumulative tightening of monetary policy, the lags with which monetary policy affected economic activity and inflation, and economic and financial developments.”

Interestingly, the media narrative generally ignored the following noting, that indicate lack of consensus on slowing the pace of hikes:

A.    “A few other participants noted that, before slowing the pace of policy rate increases, it could be advantageous to wait until the stance of policy was more clearly in restrictive territory and there were more concrete signs that inflation pressures were receding significantly.”

B.    “With monetary policy approaching a sufficiently restrictive stance, participants emphasized that the level to which the Committee ultimately raised the target range for the federal funds rate, and the evolution of the policy stance thereafter, had become more important considerations for achieving the Committee’s goals than the pace of further increases in the target range. Participants agreed that communicating this distinction to the public was important in order to reinforce the Committee’s strong commitment to returning inflation to the 2 percent objective.”

C.    “Members agreed that, in assessing the appropriate stance of monetary policy, they would continue to monitor the implications of incoming information for the economic outlook. They would be prepared to adjust the stance of monetary policy as appropriate if risks emerged that could impede the attainment of the Committee’s goals. Members agreed that their assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

D.    “Russia’s war against Ukraine is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.”

In my view, the chances are high that the Fed may slow the pace of hikes from the December meeting; but the end rate may be higher than previously estimated. We may have decisively shifted to “higher for longer” from “lower for longer” rate scenario.

More on FOMC minutes next week.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) has decided to hike the target for the benchmark federal funds rate to a range of 3.75% to 4%, its highest level since 2008. It is an unprecedented fourth hike of 75bps each at the consecutive meetings. The Committee indicated that “ongoing increases” would still likely be needed before the rates become “sufficiently restrictive” to slow down the inflation.

In a post meeting press statement, the Fed Chairman Jerome Powell said, “incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected.” He added that it was “very premature” to discuss when the Fed might pause its increases.

Further hikes could be lower than 75bps

The FOMC statement promised to take economic risks more clearly into account in deciding the size of any further rate increases. The FOMC statement read, “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."

The statement is being widely interpreted to mean that the future hikes, from the FOMC’s December 2022 meeting onwards, could be lower than 50bps. Though no dot plot (a traditional indicator of Fed official’s view on future rate hikes) was released after the meeting.

No recession, but less chance of a soft landing

Chairman Powell expressed hope that the U.S. economy can escape a recession as the Federal Reserve raises interest rates to lower inflation. He was however skeptical about the soft landing of the economy. He said that given the persistence of price pressure this year, the window of opportunity for a "soft landing" has narrowed; though he is still hopeful of a soft landing.

"Has it narrowed? Yes," Powell said at a press conference after the Fed's latest rate hike. "Is it still possible? Yes."

It is pertinent to note that signs are emerging in the US economy that a hard landing is now probable. The latest PMI came at 45. The stress in households is becoming more evident as personal savings are collapsing; credit card debt is rising at a much faster rate; over a third of the small businesses are unable to pay rent on time. The larger engine of the US economy, the consumer, has already started to stutter.

Markets disappointed

Stock markets corrected sharply after the Fed’s decision, with benchmark S&P500 shedding 2.5% and Nasdaq Composite diving 3.6%. Volumes were large as the market dived post Powell’s press statement, indicating heavy unwinding of positions.

US Dollar Index (DXY) ended more than half of a percentage point higher to close above 112.

Gold and Bitcoin were lower.

The Benchmark 10yr treasury yields were higher by 87bps at 4.10%.

 The US and European equity markets had a strong counterintuitive rally in the month of October. The benchmark indices gained 6 to 15% amidst reports of worsening economic and geopolitical conditions. The benchmark Dow Jones Industrial Average (DJIA) gained 14%, its best monthly gains since January 1976. Of course these gains have come on the back of some of the worst months in history and a pathetic overall performance in the year 2022 so far. Nonetheless, these gains have provided some relief to the embattled investors, keeping the hopes alive.

The latest meeting of the Federal Open Market Committee (FOMC) of the US Federal Reserve is being watched even more intensely, as its outcome tonight is widely expected to determine the market direction from here. One of the largest global brokerage firms J P Morgan Chase & Co. has reportedly stated that “The S&P 500 could surge at least 10% in one day if the central bank raises interest rates by a slower-than-expected half of a percentage point, and Chair Jerome Powell signals willingness at the press conference to tolerate elevated inflation and a tightening labor market”.

Apparently, lots of bets have been placed on softening of the Fed’s stance on monetary tightening. If the Fed disappoints tonight, we may see these bets unwinding; or even changing direction towards a bearish stance. A sharp reversal in the US stock markets might reverberate across markets – USD might strengthen; bonds may weaken; gold and silver may correct; and emerging markets may witness some outflows and hence give up some of the gains made in the past one month.

We shall see the expert engaged in animated discussions over Fed’s strategy and likely outcome. The market economists will term the rather hawkish monetary stance of Fed as totally unwarranted and counterproductive, citing elevated inflation and heated job markets as evidence of the ineffectiveness of the Fed’s aggressive tightening. The macro economists on the other hand would call for even more aggressive policy to completely destroy the menacing inflation and restore the credibility of monetary policy.

We shall also see buzzwords like “imminent housing crash”; “dollar debasement”; “crypto crash”; “deep recession” dominating the headlines in every form of media. A variety of experts will make prophecies about the imminent apocalypse; so that on a later date they could say “I told ya so”.

On the other hand, if the Fed obliges the markets by hiking less than 75bps; or hiking 75bps but hinting that Fed might pause sooner than earlier expected (pivot) – the market might respond as enthusiastically as people at J P Morgan et. al. are expecting. We might see an intense battle as the ‘shorts’ rush to cover and ‘longs’ happily lighten their positions.

Regardless of what Fed does and says, or refrains from doing or saying - few things appear certain:

·         The mortgage rates in the US and elsewhere will rise further.

·         Putin will maintain its hard stand on Ukraine and Europeans will be paying through teeth this winter to keep their homes warm.

·         China will continue to push its agenda of “larger role for China in global order” more aggressively.

·         Inflation will come down from a combination of demand destruction and demand transformation (as consumers move to alternative products, methods and technologies). The rate hikes will have a role to play in demand destruction but with a lag. To the contrary the impact of rate hikes on efforts to augment supplies will be visible much earlier. Higher costs would discourage capex, inventory building and debottlenecking; especially when the inflationary expectations are being managed to moderate.

Anyways, I will not stay awake till midnight to hear Mr. Powell. I am also not waiting to hear Mr. Dass tomorrow either, even in the less likely event of him choosing to make a statement post the unscheduled meeting of MPC.

As I understand from the notice of the meeting, this meeting has been called under section 45ZN of the RBI Act. The meeting under this section is called for the limited purpose of discussing and finalizing the contents of the letter to be written to the government explaining the reasons for failing to meet the set inflation targets and enumerate a corrective plan of action. Policy changes are not discussed under section 45ZN. For that a meeting under section 45ZI needs to be called.

However, if the MPC does choose to make an unscheduled hike tomorrow to catch up with the Fed, I may consider a 10-15% underweight on equities for 2023, in my investment strategy, simply because I do not like a central banker who is not in full control of monetary policy and is just managing the spreads with the US Fed.

 “Higher interest rates, slower growth and a softening labor market are all painful for the public that we serve, but they’re not as painful as failing to restore price stability and having to come back and do it down the road again.” – Jerome Powell, Chairman of the US Federal Reserve

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to hike the policy rate by another 75bps taking the federal fund rate to 3.0%-3.25% range; the highest level since 2008.

In the post meeting press statement, the Fed chairman Jerome Powell reiterated Fed’s commitment to bring down the inflation to its target level of 2%. The Fed officials indicated that the Fed would keep hiking rates further till the terminal rate of 4.6% is reached next year. This implies another possible 75bps hike in November, followed by a couple of smaller hikes in the two subsequent meetings. Quelling the market expectations of a cut next year, the fed officials hinted that no cut is seen in 2023.

Six of the nineteen FOMC members even see the terminal rates at 4.75%-5%, implying a 175bps further hike till 2023 end, before the Fed begins to scale down in 2024, bringing the rates back to below 3% only in 2025.

It is pertinent to note that there is no precedence of Fed hiking so aggressively since 1990 when the overnight funds rate was adopted as its primary policy tool. In 1994, Fed had hiked 2.25%, resorting to cuts the very next year. US Inflation had probably peaked at 9.1% ( CPI, yoy) in June, before easing to 8.3% in August.

Indicating a recession-like condition in 2023, in their quarterly estimate of rate and economic outlook, FOMC stated that unemployment rate may rise sharply to 4.4% in 2023 from the present 3.7%. FOMC scaled down its estimates for economic growth in 2023 to 1.2% and 1.7% in 2024, reflecting a bigger impact from tighter monetary policy.

From this month, the Fed has also accelerated its quantitative tightening program with US$95bn/month reduction in its US$8.9trn balance sheet.

The Fed decision did not bring any surprise for the market, as the consensus was for a 75bps hike, with a minority expecting even a 100bps hike.

·         The US benchmark indices ended the day with sharp cuts after a highly volatile session.

·         USD Index (DXY) strengthened to over 111, its highest level since April 2002.

·         Industrial metals and crude ended with over 1% cut, while Silver (2.2%) and Gold (0.6%) were higher. Bitcoin lost over 2%.

·         Bond markets quickly priced in the growing risk of a recession as the Treasury yield curve further inverted. The 2-year treasury yield over 10-year Treasury yield inverted to beyond 50-basis points.

Indian markets are also expected to open with a cut of about 1%.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) is scheduled to announce its latest assessment of the economy and its policy stance tomorrow. A large number of market participants are waiting to hear the Fed chairman, with bated breath. I expect a large number of traders in India to stay awake till midnight to hear Mr. Powell, even though they cannot initiate any trade until 9:15AM on Thursday, when the Indian markets open for trading. Therefore, literally speaking, losing sleep to hear the Fed statement is of little consequence.

The market consensus is for a 75bps hike in the policy bank rate and an unambiguous hawkish stance unlike the previous statement in July, when the Fed sounded little ambivalent about the future hikes. Some experts are expecting even a steeper 100bps hike and raise in the terminal bank rate target to 4.5% (from previously estimated 3.75-4%) by April 2023. This implies a total of 200bps expected hike between September 2022 and April 2023; the steepest hike in the past two decades.

Since March 2022, when the Fed started to hike rates to bring down the inflation, an interesting contest has been seen between markets and the Fed.

1.    The benchmark S&P500 has moved higher after hearing the Fed on 3 of the 4 occasions. Obviously, the messaging of the Fed to the market was lacking in clarity and intent.

 

2.    One of the reasons for defiance of stock prices despite sharp rate hikes is that the Fed has not been able to materially influence the long term yields so far. The US yield curve has inverted sharply in the past six months, indicating that the markets are assuming a sharper recession and a quick reversal in the rate hike cycle (as early as 2H2023).

3.    The commodity prices have not yet corrected in line with the stance of central bankers and forecasts of severe recession. Bloomberg Commodity Index is still higher than the level it was at the beginning of the rate hikes in March 2022; and so has been the inflation. Consequently, the US rates have become sharply negative severely hurting the savers.

 

Obviously, more than the action, the Fed perhaps needs to tighten its messaging to the markets. For example, a clear message that the inflation is not seen coming below the Fed’s upper tolerance band at least till the end of 2023 and it would not be prudent to expect a rate cut before 2Q2024, could make the market reactions more congruent to the Fed’s policy stance.

 Hikes another 75bps

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) hiked the federal fund rate by 75bps yesterday to the range of 2.25% - 2.50%. This is the second 75bps hike in two months. In the post meeting press interaction the Fed chairman Jerome Powell outrightly rejected the speculations that the US economy is in recession. The FOMC members are of the opinion that the strong labor market allows the US economy to tolerate rapid monetary tightening.

For the first time since February 2020, the FOMC statement did not mention Covid or coronavirus.

…leaves the door open for further data dependent hikes

Reiterating the commitment to achieve the 2% inflation target, Powell also indicated that while another unusually large increase could be appropriate at our next meeting, the FOMC would set policy on a meeting-by-meeting basis rather than offer explicit guidance on the size of their next rate move, as he has done recently; thus, leaving the future course of the FOMC action wide open.

As per the Bloomberg estimates, the market consensus is now gathering around two more 50bps hikes in September and December FOMC meetings, with the fed fund rate peeking around 3.4%, lower than the previously estimated 3.8%.

The US economy is estimated to have grown at a tepid 0.4% (QoQ, annualized) rate in 2Q2022 after recording a negative growth in 1Q2022, technically avoiding a recession. The US officially acknowledges a recession if the economy logs a negative growth for two consecutive quarters.

Markets react positively to FOMC – stock rally, yields and USD tumble

The markets took comfort from the growth outlook and Powell’s statement on future rates being data dependent. The market participants appear to have concluded that the FOMC may reach the end of the tightening cycle by the end of 2022, triggering a “risk on” rally in the markets.

·         Battered tech stocks surged strongly with the benchmark Nasdaq rising 4.06%, the largest one day gain since November 2020. The broader index S&P500 gained 2.62%.

·         US Dollar Index lost 0.66%.

·         2yr SU Treasury yields fell 10bps; while 10yr benchmark yields were down 5bps at 2.78%.

…but deeper yield curve inversion signals recession as consensus

The US yield curve is now inverted the most in two decades, highlighting that the markets strongly believe a recession is around the corner. The 2yr yields are now over 30bps lower than the benchmark 10yr yields – clearly indicating that the market sees higher risk of recession than the Fed. The deeper yield curve inversion is seen to imply that Fed may actually return to the path of easing as early as 2023.

Click here to see a nice compilation of analysts’ reactions to the FOMC statement.

 In the next couple of days, the market participants world over will be focused on the FOMC statement on Fed rates, inflation & growth outlook and guidance for the monetary policy direction in the near term (next 3-6months). The “active” market participants in India, in particular, would be staying awake till late midnight on Wednesday to hear what Fed Chairman Jerome Powell has to say.

The fact that Thursday happens to be the monthly derivative settlement for July contracts, makes the Fed decision, and likely reaction in our markets on Thursday morning, even more pertinent for the derivative traders in India.

Besides the derivative traders, the currency traders; bond traders and corporate treasury managers who need to actively manage their Fx exposure, would also staying awake to see how the US Dollar, EUR and US Treasuries behaves post the FOMC statement and try to assess how Indian bonds and INR may react in near term.

Our markets may however be relieved to a great deal if the RBI makes an unscheduled rate decision on Wednesday morning itself, just like it did on 4 May 2022, preempting the pressure on Indian bonds and INR post FOMC decision. For records, in his recent statement, the RBI governor has already spoken about the inevitability of further rate hikes. It would be better if it is done tomorrow rather than a week later (04 August 2022) when the MPC of RBI is scheduled to make a statement on monetary policy.

The European Central Bank (ECB), for example, hiked 50bps last week – their first hike in 11 years- to preempt further slide in the Euro. ECB hiked despite signs of accelerated slowdown in growth and rising fiscal pressures on peripheral Europe.

Since the FOMC decision would be known in less than two days, I do not find any need to speculate on the likely outcome and the market reaction to that outcome. Nonetheless, it would be appropriate to say that the market is pregnant with the hope of a unambiguous ‘pause’ signal from the Fed and consequent weakness in USD and a rather dovish MPC. The chances of disappointment are therefore marginally higher than the chances of positive surprise, in my view.

What should be the strategy of an investor under these circumstances?

In my view, the first thing an investor should do is to have a good dinner on Wednesday; go to bed early and not watch the markets, including business newspapers & TV channels and investing handles on social media, on Thursday.

Second, investors should focus on performance of the companies in their respective portfolio, rather than bothering too much about the general impact of global macro developments. They should assess the ability of the companies in their portfolio to manage the impact of rate and currency volatility on their respective businesses. The history indicates that better managed companies in India have managed this volatility very well without letting it materially impact their performance beyond a couple of quarters in the worst case.

Third, if the change in global rate and currency outlook materially alters the investment argument for a company in their portfolio, they should place a “sell” order for it today itself.

The Federal Open Market Committee (FOMC) of the US Federal Reserve decided to hike the benchmark bank rate by 75bps to 1.5% - 1.75% on Wednesday. The Committee also reiterated that the Fed will continue to shrink its balance sheet by US$47.5bn till August 2022 and from September the unwinding will be stepped up by US$95bn/month. The FOMC noted that there is no sign of broader slowdown in the economy, while lowering its GDP growth forecast for 2022 to 1.7% from 2.8% earlier. The FOMC statement reiterated the strong commitment to achieve the 2% inflation target. The Fed Officials projected raising it to 3.4% by year-end, implying another 175 basis points of tightening this year. The projection shows a rate cut in 2024.

In the post meeting press meet, Chairman Powell commented that “Either a 50 basis point or a 75 basis-point increase seems most likely at our next meeting. We will, however, make our decisions meeting by meeting.” The Chairman added that ““It does appear that the US economy is in a strong position, and well positioned to deal with higher interest rates.”

The US markets reacted favorably to the FOMC decision. The benchmark S&P500 ended 1.46% higher and 10yr benchmark yields fell 3% to 3.29%. 

Lately, I have been reading a lot of views and opinions about the likely outcome. There are strong arguments for a long corrective phase in the US Economy, just like Japan witnessed post the fiscal and monetary profligation of the 1970s. This Volckerish view anticipates a hard landing for the US economy; tremors across the world and gradual decoupling of global markets from the US markets. The other, equally stronger view is aggressive Fed hikes and tightening taming inflation but not without material demand destruction (recession) followed by a deflationary cycle. This Greenspanish view implies a soft landing for the US economy, premature end to Fed tightening and restoration of “Fed Put” for quick market revival.

Besides, there are multiple views that completely deny the independence of the US Fed from domestic politics and geopolitics. One view, though not convincing enough, portends that the US Fed will be forced to abandon its tightening stance before the mid-term polls begin in the US. The other view is that the inevitable end of current hostilities between Russia and Ukraine would mark the end of the global supply chain woes, resulting in reversal of cost pushed inflation; and the global central bankers’ focus will return to financial stability and growth.

Honestly, with each page of additional reading my confusion has compounded exponentially. In fact, I am confused, like never before, about the basic economic concepts like interest rates, inflation, free markets etc.

What I studied in school was that “inflation” is the rate of rise in prices of goods and services over a defined period. For example, if I could buy a basket of groceries for Rs1000 in June 2021; and I have to pay Rs1100 for the same basket in June 2022; the rate of annual inflation for June 2022 is 10%. If the same rate of inflation persists, the price I would need to pay for the same basket in June 2023 would be Rs1210.

If my income grows at the same rate during this period, I will continue to buy the same basket and there would be no change in my lifestyle (just for example). If my income does not grow by 10%, I will have to cut my consumption or borrow money to maintain my lifestyle. In the first case, the demand for groceries would fall and the seller will be forced to cut prices and the inflation will come down and I will be able to afford the same basket of groceries after some time. In the second case, the inflation for groceries will not come down as the demand sustains; but the demand for money (credit) will rise resulting in higher price for money (interest rates). This means in a simple environment higher interest rates and higher inflation could have positive correlation and move in tandem.

However, the inflation-interest rate correlation will turn negative if (in the above example) I borrowed money in the year 2021 itself and I cannot make additional borrowing to meet higher cost of groceries. In this case, even if my income grows to match the grocery inflation, I will have to cut my consumption to meet the rise in my interest expense.

This implies that other things remaining the same, and it being a free market economy, the correlation of inflation and interest rates would depend on the extent of extant leverage in the economy.

The situation however gets complicated when the largest consumer and borrower (the government) is in a position to control the price of money (interest rates) and/or goods & services. For example, if the government (or central bank) increases money supplies and also cuts the price of money (interest rate) the consumption demand could become artificially high, resulting in higher consumer price inflation. The problem gets further complicated if the government is able to manipulate the purchasing power of the currency (exchange rate) and thus also artificially contain the consumer inflation.

The present situation in the US, as per my understanding, is like this:

The US Fed has increased the money supply (M2) by more than ~3x in the past 13years; while maintaining the price of money (interest rates) close to zero. The exchange rate of USD (DXY Index) has appreciated by about 25% during this period. The inflation was therefore artificially suppressed for over a decade.

The “shutdown” of the global economy in the wake of the pandemic breakout, made the cheaper money and expensive currency irrelevant as the real goods and services were in short supply. The war in Europe further complicated the situation of goods and services supply.

Now, the US central bank is trying to find a lower demand-supply (price) equilibrium by (a) reducing the money supply; (b) increasing the price of money (to contain the consumption demand) while (c) maintaining the currency exchange rate at high level (to ensure cheaper imports).

The debate now is about the trajectory of (i) consumption demand destruction; and (b) improvement in supply of goods and services. A steep fall in demand and steep improvement in supply chains could normalize the situation without much damage to the basic fabric of the economy. However, if the trajectory is flatter, the pain may linger on for years or may be decades.

The other solution could be to control the consumption and prices of goods and services also (Marxist model). This will obviously destroy the basic fabric of the US economy as it stands today.

Insofar as India is concerned, our situation is fairly simple. We have limited leverage and the government intermittently controls the prices of money as well as goods & services, especially during the period of crisis. We just need to pray to Lord Indra for good rains and pray to Lord Ganpati for giving some sanity to Mr. Putin and Mr. Zelenskyy. If these two prayers are answered favorably, we shall be in a position to decouple from US markets and charter our own course (or find a more favorable benchmark to follow). Rest all is ok.