Federal Reserve moves towards bond purchases tapering

The Federal Reserve is meeting on the 3rd of November. It will almost certainly announce a tapering of its bond purchases. The current pace is 120bn dollars per month with 80bn in Treasuries and 20bn in Mortgages. The odds are that it will reduce the US Treasury purchases by 10 billion each month and mortgage purchases by 5 billion. It is most likely to keep the option to decelerate this pace if the economy deteriorates leaving most likely the program to finish around July 2022 (Q3 is decelerating somewhat more than expected). The Fed will probably also ramp up its communication policy by turning more hawkish to convince households — and, to a lesser extent, the financial markets — that they are tackling the risk of elevated inflation. One way they can do this is by the Fed’s message on interest rates.

Inflation is both a local and global problem
Inflation is a global issue because supply chains are stretched to the breaking point by past closures of plants, transportation issues (see graph below) and aggressive historic monetary policy across the world. The global economy has hence heated up much faster than expected as supply couldn’t keep up — to put it more technically, because the output gap shrank. Faced with a mixture of short-term and long-term shocks and some uncertainty as to whether this increased demand for goods is actually there to stay, supply simply isn’t increasing fast enough. Investors are caught wondering whether, for example, it’s worth investing in a new factory if supply will sharply increase globally in a few years. The answer is not so obvious if governments and central banks can’t promise a decent pace of long-term growth. This is particularly the case in China. As a result, this part of the inflationary pressure could persist for a while.

Note: The number of vessels at anchor of LA has been steadily picking up as processing can’t keep up with the surge of goods for the holidays which should lead to empty shelves in stores

An earlier pace of rate hikes
To take back control of the inflation narrative, the FOMC is probably set to signal an earlier and slightly faster pace of rate hikes than is currently indicated by the Fed forecasts (Fed Dot-Plots). It is therefore probable that it will signal a rate hike at the end of 2022. Currently, half of the FOMC expects a 25bp hike as early as 2022, while the market prices in two 25bp rate hikes by then. If the Non-Farm payroll released next Friday comes in as expected at or above 390K, we expect that to trigger the Fed to taper.

What does it mean?

The market expects inflation to be elevated for longer, but over time, central banks’ credibility and longer-term forces deflationary forces (automation, outsourcing, ageing..) should work in the opposite direction. Inflation break-evens should eventually drop and with it the US Treasury curve should flatten, leading Credit including High Yield to outperform. As the mix of growth and inflation eventually improves, we should see the dollar strengthen versus the euro and yen.

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