USD Rates: Nimble Fed goes for optionality

Fed gets ready to hike.
Eugene Leow27 Jan 2022
    Photo credit: Unsplash Photo

    Overnight, the US Federal Reserve’s Open Market Committee maintained that QE would end in March while signalling that rate hikes may be imminent. Meanwhile, the Fed also laid out principles for reducing the size of its balance sheet. USD rates were initially calm but adjusted sharply higher after Fed Chair Powell indicated that there is a need to be “nimble” on inflation. Notably, there was no mention of “gradual” in the impending hike cycle. Market participants, who have turned neutral ahead of this meeting, interpreted that to mean every FOMC meeting could be live and that the possibility of a 50bps move should not be ruled out. The US Treasuries curve bear flattened, with 10Y yields closing at 1.87%. Note that Fed Feds futures are now pricing a tad more than four hikes in 2022. This marks the most aggressive pricing thus far this year. 

    The key takeaway is that the rate hike cycle is about to start. While the market is factoring in a run rate of 25bps/quarter, the odds of a more aggressive frontloading of rate hikes should no longer be dismissed. Inflation (at 7%) is clearly uncomfortably high. The Fed has two more data points on this before the March meeting. If headline CPI does not come off meaningfully, there may be more catch up to do. There is a reasonable chance that the March dot-plot would show four hikes in 2022. Accordingly, we also see upside risks to our Fed call of three hikes each in 2022 and 2023.

    Market developments are not serious enough to deter the Fed. We can quantify this by looking at financial conditions (comprised of equity performance and credit spreads) and how the Fed tends to behave. Clearly, loose financial conditions provides the Fed with more leeway to hike rates. However, it would also take a serious disruption in the financial markets before the Fed is nudged back from hikes. The equity correction thus far is still far from the threshold, in our opinion.

    While there are scant details on quantitative tightening (QT), the principles laid out suggests that the Fed would allow holdings to mature. However, there was also an indication that the Fed prefers to hold USTs over other assets (largely MBS). This could mean some active selling of MBS (some of the SOMA holdings are of very long maturity) at some point. We estimate that there are some USD 3tn (RRP facility and free reserves) in excess liquidity in the US financial system. This would allow the Fed to QT at a more aggressive pace than during the last cycle. We think QT can start in mid-2022, with a terminal pace of USD 100bn/month. The impact on USD liquidity should be negligible for many quarters. However, the impact on duration, which increases term premium, would be increasingly felt.

    Eugene Leow

    Senior Rates Strategist - G3 & Asia
    [email protected]

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