Bassanese Bites: Powell’s Pivot – December 06 2021

Global Markets

Global equities suffered another set back last week, due to both lingering Omicron fears and a new risk factor on the horizon – a more hawkish U.S. Federal Reserve.

Without doubt, last’s week’s comments by Fed chair Powell were ground shifting: he openly talked about the potential need to accelerate bond tapering and also suggested we stop using the term “transitory” to describe inflation.  The Fed is worried: due to very strong demand (fuelled in large part by excessive fiscal stimulus), lingering COVID-related global supply chain disruptions and a puzzling unwillingness of millions of Americans to return the workforce, inflation and wage growth in the world’s largest economy has taken off, and does not look like abating anytime soon. As Powell conceded, the big policy mistake this year was to underestimate the ability of supply to meet the stimulus driven boost in demand.

As evident in last Friday’s U.S. November payrolls report, worker shortages led to a weaker than expected 210K gain in employment and a sharp drop in the unemployment rate from 4.6% to 4.2%. There was a welcome but glacial lift in the labour force participation rate, from 61.6% to 61.8% – compared to a pre-COVID high of 63.4%.  Annual growth in average hourly earnings held steady at 4.8%.

The Fed is now on alert to ensure demand more closely matches supply in 2022 – lest inflation persist and inflation expectations ratchet higher. Hopefully most of this mismatch can come via higher supply, but if not growth will have to slow and higher rates will be required to make it happen.

Bottom line: to my mind, accelerated Fed bond tapering (a quickened reduction in bond purchases) is a done deal at next week’s December 14-15 policy meeting.  This should mean the Fed will have finished bond buying by around end-March 2022, not end-June. In turn that opens up the possibility of Fed rate hikes as early as the May 3-4 meeting. Either way, my base case now is that the Fed will hike rates three times in 2022, with US 10-year bond yields likely to touch 2.25% at some point as interest rate fears reach a peak.

Despite this, I still don’t expect the RBA to hike rates next year, which suggests local bonds should outperform and the $A could sink further below US 70c. My earlier call of the $A falling to around US68c remains in place. While earnings growth should remain solid, still elevated price-to-earnings valuations make equity markets increasingly vulnerable to a correction next year of at least around 10% – though something a lot worse seems unlikely barring a US recession.

In terms of the week ahead, markets will remain watchful of Omicron developments, with a seemingly inevitable further surge in global reported cases likely. That said, I suspect markets will grow more comfortable on this front provided early reports of only mild symptoms are sustained.  The Fed to my mind is the bigger worry – and on this front another uncomfortably high U.S. consumer price index report on Friday will be the other big market focus this week.

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