Bearish Impact of Federal Reserve's Hawkish Stance: Delayed Rate Cuts, Omission of 'Banking System Soundness' Comment

The Federal Reserve's recent meeting on December 13th has caused a stir in the market, with the dollar decreasing and bonds, gold, and bitcoin all increasing. This is due to the expectation of further quantitative easing or "buy all the things" approach.

Source: Bloomberg

While all yields have decreased since the last meeting, the short-term yields have seen a significant improvement, while the long-term yields have only recently started to recover. This has resulted in a steepening of the yield curve, with a swing from -45bps to +10bps for the 2s30s spread.

Source: Bloomberg

During the meeting, the New York Branch of the Federal Reserve experienced a major disruption, causing traders to seek safe-haven assets such as gold and bonds. This led to an increase in expectations for rate cuts, putting the Fed in a difficult position of having to counter the market's demands after previously trying to influence it through verbal persuasion.

As expected, the FOMC voted unanimously to keep the benchmark rate unchanged at 5.25%-5.5% for the fourth consecutive meeting. However, the statement released by the Fed was surprisingly more hawkish than anticipated. The Committee made it clear that they do not plan on reducing the target range until they are confident that inflation is moving towards their goal of 2%.

Despite this, the Fed did leave room for potential rate cuts in the future, stating that the risks to achieving their employment and inflation goals are becoming more balanced. They also removed any mention of tighter financial conditions, which is understandable given the current loosened state of financial markets.

In a possible acknowledgement of the positive sentiment in the economy, the Fed removed any reference to slowing growth from its previous statement.

One significant change in the recent statement from The Fed is the removal of the sentence stating that the U.S. banking system is sound and resilient. This decision may have been influenced by the current situation at NYCB and the anticipated chaos in March. It raises the question of whether the absence of this statement implies that the banking system is no longer stable, or if it was simply a false claim made to reassure the public. The revised statement has received widespread criticism. Some argue that it is a sign of the Fed's lack of confidence in the banking system, while others believe it is an attempt to be more transparent and honest with the public.

The Hawkish Fed's Impact on the Market

The Immediate Reaction

The market's initial reaction to the Fed's statement was a sharp decline in the dollar index, which measures the value of the U.S. dollar against a basket of other currencies. This was followed by an increase in bond yields, gold prices, and bitcoin. The stock market also saw a slight decrease, with the S&P 500 falling by 0.3%.

This immediate reaction can be attributed to the market's expectation of further rate cuts and quantitative easing. The Fed's decision to maintain the current interest rate range and their hawkish stance caught many investors off guard, leading to a sell-off in the dollar and a shift towards safe-haven assets.

The Steepening Yield Curve

One of the most significant impacts of the Fed's statement was the steepening of the yield curve. The yield curve is a graph that plots the yields of bonds with different maturities. A steepening yield curve indicates that long-term yields are increasing at a faster rate than short-term yields.

In the days following the Fed's meeting, the 2s30s spread, which measures the difference between the 2-year and 30-year Treasury yields, saw a significant increase from -45bps to +10bps. This steepening of the yield curve is a sign of increased optimism in the economy, as investors are willing to take on more risk in the long-term.

However, some experts warn that this steepening could also be a result of the market's expectation of future rate cuts. If the Fed does not follow through with these cuts, the yield curve could flatten again, indicating a lack of confidence in the economy.

The Impact on Borrowing Costs

The steepening of the yield curve also has implications for borrowing costs. As long-term yields increase, it becomes more expensive for businesses and individuals to borrow money for longer periods. This could potentially slow down economic growth as businesses may be less inclined to invest in long-term projects.

On the other hand, short-term yields have remained relatively low, making it easier for businesses and individuals to borrow money for shorter periods. This could lead to an increase in consumer spending and business investment, which would stimulate economic growth.

The Dollar's Decline

The dollar index saw a sharp decline following the Fed's statement, reaching its lowest level since July. This can be attributed to the market's expectation of further rate cuts, which would decrease the value of the dollar.

A weaker dollar can have both positive and negative impacts on the economy. On one hand, it makes U.S. exports more competitive, boosting economic growth. On the other hand, it makes imports more expensive, leading to higher inflation.

Impact on International Trade

The decline of the dollar could also have significant implications for international trade. A weaker dollar makes U.S. goods and services more affordable for foreign buyers, potentially increasing demand for American products. This could help reduce the U.S. trade deficit, which has been a major concern for the Trump administration.

However, a weaker dollar could also lead to retaliation from other countries, as they may see it as an attempt by the U.S. to gain an unfair advantage in trade. This could potentially escalate into a trade war, which would harm the global economy.

FAQs

What is the Federal Reserve?

The Federal Reserve, also known as the Fed, is the central banking system of the United States. It is responsible for conducting monetary policy, supervising and regulating banks, and maintaining financial stability.

What is a hawkish stance?

A hawkish stance refers to a central bank's policy of raising interest rates to control inflation and maintain financial stability. This approach is often seen as more conservative and cautious compared to a dovish stance, which involves lowering interest rates to stimulate economic growth.

What is quantitative easing?

Quantitative easing is a monetary policy tool used by central banks to stimulate the economy. It involves buying government securities or other assets from financial institutions to increase the money supply and lower interest rates.

How does the Fed's decision impact the stock market?

The Fed's decision can have a significant impact on the stock market, as it affects borrowing costs, inflation, and economic growth. A hawkish stance could lead to higher borrowing costs and slower economic growth, which could negatively impact the stock market.

Will there be any rate cuts in the future?

While the Fed has left room for potential rate cuts in the future, they have stated that they will only consider them once inflation is moving towards their target of 2%. The decision to cut rates will depend on the state of the economy and the level of inflation at that time.

Conclusion

The recent meeting of the Federal Reserve has caused a stir in the market, with the dollar declining and bond yields increasing. The Fed's decision to maintain the current interest rate range and their hawkish stance caught many investors off guard, leading to a shift towards safe-haven assets. The steepening of the yield curve and the decline of the dollar have significant implications for the economy, including borrowing costs, international trade, and the stock market. While the Fed has left room for potential rate cuts in the future, their decision will ultimately depend on the state of the economy and inflation levels. As always, it is important for investors to stay informed and adapt to any changes in the market.