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Fed out-hawks markets – for now

The Federal Reserve turned remarkably optimistic yesterday. Growth forecasts were doubled for this year and raised by more than a third for 2024, projections for the unemployment rate were cut from 4.5 percent to 4.1 over the next two years, and core inflation was still seen falling below 3 percent within a year. 

Markets turned more cautious. Odds on a rate hike at the end of this year inched higher and the number of cuts expected in 2024 dropped from four to three. Treasury yields jumped across most of the curve and equity indices tumbled, pushing the dollar higher against its major rivals. 

As the North American session resumes this morning, measures of expected turbulence are creeping up. The VIX implied volatility index – known as the “fear gauge” – is near a three-week high, risk reversals in most major currency pairs are pointing to wider ranges ahead, and high-beta assets like gold and crude oil are coming under pressure. The Canadian dollar’s sensitivity to US equity markets and commodity prices is exacting a toll, with the dollar-loonie exchange rare falling back through the 1.35 mark in Asian trading hours. 

We’re not sure how long this will last. By issuing a set of forecasts that would make Goldilocks blush, Fed officials may have tried to forestall an undesired easing in financial conditions, but similar rhetorical efforts have been swiftly unwound in markets in the days after each meeting this year. There’s little to suggest that this time will play out differently. 

The Bank of England kept benchmark interest rates unchanged following August’s cooling in price pressures. In a narrowly-balanced four-against-five decision, Governor Bailey and his colleagues on the Monetary Policy Committee said “Inflation has fallen a lot in recent months, and we think it will continue to do so. That’s welcome news. But there is no room for complacency. We need to be sure inflation returns to normal and we will continue to take the decisions necessary to do just that”. “Monetary policy will need to be sufficiently restrictive for sufficiently long to return inflation to the 2 percent target sustainably in the medium term”. The rate decision, which was somewhat offset by an acceleration in the planned pace of quantitative tightening – from £80 billion in 2022-23 to £100 billion in 2023-24 – smashed terminal rate expectations back to 5.45 percent and sent the pound spiralling below 1.23 against the dollar. 

Earlier, the Swiss central bank unexpectedly held rates, triggering sharp losses in the franc. The Norges Bank and Riksbank lifted their benchmarks by a quarter point each, while the Brazilian central bank moved in the opposite direction, cutting rates by half a point. The move aligned with other Latin American central banks – Paraguay, Peru, Chile, and Uruguay have all moved into reverse in recent months – and with the trend in broader emerging markets, where carry yields are expected to continue falling in the months ahead. We note that Mexico’s stronger US links and less dovish central bank could help the peso remain a relative outperformer against this backdrop. 

A raft of second-tier US data releases will land this morning, helping add nuance to yesterday’s moves. Numbers out in half an hour are expected to show the number of initial claims for unemployment benefits rising to 225,000 last week, up from 220,000 in the prior week. The current account is seen widening to $222 billion in the second quarter, and the Philly Fed’s manufacturing index is likely to fall, reflecting a softening across the global industrial production cycle. Later, the Conference Board’s leading economic indicator index for August is expected to fall 0.5 percent from July – but structural changes in the economy and the unique nature of the post-pandemic recovery have raised serious questions about the measure’s effectiveness in helping economists predict a downturn. 

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Higher for (even) longer