Mon, 25 Oct 2021

Following the latest FOMC meeting and press conference, financial markets turned again towards prospects for interest rates, as the largest central bank in the world provided stronger tapering signals.

Monetary policy normalization can have a meaningful impact on asset valuations, especially if interest rates, both on the short and long end of the curve, will start to rise. Volatility in the stock markets increased, as a series of converging factors were no longer supporting a continuation of the bull run.

In terms of the Federal Reserve's Funds Rate projections, things have changed after the latest meeting and if those projections turn out to be true, the first liftoff will occur sooner than what the market expected several months ago.

December 2022 rate hike

The Fed tapering program is expected to be announced at the November 2021 meeting and based on the information provided by Jerome Powell, asset purchases will reach 0 by mid-2022. However, on top of that, the futures market is now pricing in an 80% probability for an interest rate hike in December 2022, contrary to expectations for a prolonged period with low short-term rates.

A higher cost of capital will mean companies, the government, and the wider public will not have easy access to funding, which might put a new headwind on the already slowing economic expansion. Another issue now faced by central banks is rising inflation, which is projected to remain elevated for the next few months, prompting policymakers to take measures.

Tapering required as a result of high inflation

Supply bottlenecks remain the main cause of rising inflation, combined with record energy prices. Inflation in the USA and Europe is already at levels not seen since the 2008 financial crisis and as things are expected to get worse during the winter, adjusting both monetary and fiscal policy remains a key challenge.

Those who are learning to trade currencies are now seeing the US dollar rising close to a one-year high, given the Federal Reserve is expected to be the first major central bank in line when it comes to normalizing monetary policy.

That creates a positive feedback loop for the USD, as market participants sell other currencies in exchange for dollars. At the same time, this is the global reserve currency, and a higher USD can temper rising commodity prices.

How financial assets could perform?

All the major stock markets have peaked in the short term and now are facing the first significant correction for 2021. Rising inflation remains the main concern, given it already leads to weakening economic activity. This creates concerns related to stagflationary winds, a phenomenon that did not occur since the '70s.

In the commodities space, the imbalance between supply and demand should put a bid under prices for the next few months, even though policymakers might intervene to stabilize the situation. Lastly, long-term borrowing costs are expected to rise, as long as inflation does not show any sign of peaking.

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