Fed’s ‘Remarkable Turn’ Puts Big Red Circle Around March

“We’re at a point in time where we need to adjust policy,” Mary Daly said Friday, as the curtain closed on an inauspicious start to the new year for US equities, which struggled to digest the largest one-week rise in real yields since the tumultuous days of March 2020.

Markets surely aren’t that surprised at the Fed’s hawkish pivot. After all, sundry pundits spent the better part of Q4 shouting from the rooftops about the urgency inherent in scorching inflation prints and the Fed’s developed market peers shifted decidedly hawkish in October (the BoE made up for a befuddling November hold with December’s hike). Jerome Powell telegraphed the pivot when he formally jettisoned “transitory” in remarks to Congress, and it was clear from last month’s post-FOMC press conference that the conversation had already shifted to balance sheet runoff.

Nevertheless, the December FOMC minutes were, as I put it, “perhaps more explicit than expected regarding the runoff discussion,” and that’s to say nothing of what many believe is the Committee’s intent to prepare markets for liftoff in March. That’s quite the about-face. In six months, we’ve gone from “transitory” and no hikes until at least 2023 to an accelerated taper, an “ASAP” timeline on liftoff and similarly urgent messaging around the onset of runoff. Seen in that light, it’s little wonder reals reacted as violently as they did (figure below).

Just as the Fed is effectively marking policy to market (both in terms of aligning with market expectations for hikes and catching up to non-transitory inflation), so too is Wall Street now marking its Fed calls to the policy pivot.

A few seconds after the December minutes were released, I wrote that “it looks as though March is a go for liftoff.” By Friday, JPMorgan, Deutsche Bank and a handful of others were all on board. Goldman shifted their call weeks ago.

“It may be a tough sell to hold off on the first hike until June,” JPMorgan’s Michael Feroli said, citing labor market tightness. “We now see liftoff in March, followed by a quarterly pace of hikes thereafter,” he added, formally bringing forward the bank’s call.

To reiterate (and I realize this scarcely needs repeating), that means the Fed is likely to pull the trigger on the first hike literally as soon as possible, considering the pace of the taper. Hiking rates while actively increasing the size of the balance sheet makes no sense (you’re driving with one foot on the accelerator and one on the brake pedal), so the earliest opportunity for liftoff is March (figure below).

“Markets may be facing a [rate hike] before the end of March, with balance sheet contraction starting shortly thereafter… a remarkably hawkish turn of events considering the central bank is still making QE purchases,” JonesTrading’s Mike O’Rourke marveled.

In a Friday note, following the December jobs report, Deutsche Bank’s Matt Luzzetti officially changed the bank’s liftoff call to March. The bank now sees four hikes in 2022, and suggested the Fed might even opt for 50bps in a single meeting depending on the circumstances.

After saying quarterly hikes are the most likely scenario, Luzzetti wrote that “the Fed will clearly be very nimble in responding to the incoming data, making consecutive rate hikes or even larger increments possible.”

Of course, he also allowed for the possibility that an abrupt tightening of financial conditions (e.g., a 30bps move higher in real yields over just five days) could prompt a “pause” from the Fed if tightening “becomes too disruptive.”

Luzzetti sees balance sheet rundown commencing in Q3, with an announcement on runoff caps “around” the May meeting and the onset of QT in August. “Our preliminary calculations suggest that while runoff would be $300-400 billion in the second half of this year depending on how they structure the caps, it would be around $1 trillion in 2023, representing a significant tightening of financial conditions that would equate to roughly two hikes in total,” he added.