By Michael O’Neill
“We gotta get ready, we gotta get right, interest rates are going higher, they may go out of sight.”
The Russian invasion of Ukraine gave investors a brief reprieve. Federal Open Market Committee (FOMC) members wanted to hike the fed funds rate by 0.50 bps on March 16 but opted for just a 0.25% increase due to “greater near term uncertainty” associated with the hostilities.
Relieved equity traders bought stocks, taking the S&P 500 index from its March 15 low of 4,187.90 to a peak of 4,637.30 March 29, before consolidating in the first few days of April. Traders took comfort in forecasts suggesting the terminal rate for fed funds was in the 2.50-2.75% area, and analysts predicting the S&P500 to reach 4,900-5,000 by year-end. They appeared to dismiss concerns about rising inflation levels.
That changed rather abruptly on April 5. Soon to be Vice-Chair (awaiting full-Senate confirmation), Lael Brainard warned that rate hikes may be more aggressive and balance sheet reduction will occur at a more “rapid pace.”
Equity traders reacted like her comments were a surprise. Global stock indexes dropped, and the S&P 500 index touched 4,450 on April 6. Treasury yields spiked to 2.65%, last seen in February 2019. The US dollar rallied, driving the US dollar index (USDX) to 99.80.
So why did markets react to Brainard’s hawkish comments but mostly ignore similar remarks from New York Fed President John Williams, Board Member Christopher Waller, or Chicago Fed President Charles Evans?
Perhaps because Ms Brainard’s elevation to Vice-Chair makes her the second most powerful member of the FOMC, suggesting her words carry nearly as much weight as those from Chair Powell.
She’s no dummy, either, holding a PhD from Harvard
She has a wealth of experience in policymaking. She was a deputy national economic advisor to President Bill Clinton and the Under Secretary of the Treasury for International Affairs under Barak Obama.
Ms Brainard said the Fed would begin reducing the balance sheet at a rapid pace. Some believe that the effect is interest rate hikes on steroids. Quantitative Easing was a tool employed by the Fed to stimulate the economy by lowering interest rates. Balance sheet reduction or Quantitative Tightening has the opposite effect.
However, St Louis Fed President Jim Bullard said that “the financial and macroeconomic effects of QE and QT may be asymmetric.” He noted that QE provides a valuable signal when rates are near zero, but when rates are well above zero, any signaling from the balance sheet have dissipated.
The Fed isn’t the only central bank adopting an aggressive tightening program. The Bank of Canada steps to the plate and is widely expected to swing a big bat on April 13.
Last week, Deputy Governor Sharon Kozicki set the stage for a 0.50% rate hike when she said, “inflation in Canada is too high, labour markets are tight, and there is considerable momentum in demand.” Policymakers are concerned with the broadening of price pressures—around two-thirds of the components in the consumer price index are now exhibiting inflation above 3%, and fear longer-run inflation expectations could drift upward.
Rising Canadian interest rates suggest further gains for the Canadian dollar, especially against the Australian dollar, Japanese yen, and Euro.
The Reserve Bank of Australia is reluctant to hike interest rates as the Governor insists that rates will remain low until inflation is sustainably in the 2-3% target range. Australia’s core inflation is 2.6%, while the headline rate is 3.6%.
The Bank of Japan is sticking to its accommodative monetary policy and actively working to keep 10=year JGB yields below 0.25%.
The ECB stubbornly believes inflation will return to targeted levels within “two-three years” and is now handcuffed by Russia’s invasion of Ukraine. The risk of a war-triggered EU recession is rising, and hiking interest rates is counter-productive.
Interest rate differentials make a difference and they will favour the Canadian dollar over AUD, JPY and EUR.
The Canadian dollar also benefits from WTI oil prices that remain in an uptrend above $85.00/barrel. Analysts expect steady to higher prices due to supply disruptions from Russia and booming global demand.
Canada’s stature as an oil nation got a bit of a boost. The Federal government approved the Bay du Nord project in Newfoundland, which has around 300 million of recoverable barrels. The Fed said that the fact that seven of the eight MPs in the province are Liberals had no bearing on the decision.
The USDCAD technicals are bearish. The failure to break above 1.3000 earlier this year, followed by the move below significant support in the 1.2620 area targets 1.2000. Seasonal factors suggest the move could occur by the end of June.
The new world (interest order) has arrived, and rates are going higher until inflation has been tamed.