Asian equities posted marginal losses at Tuesday’s open as renewed debate over the Federal Reserve’s policy tightening stance, coupled with rising bond yields, tempered gains in US equities.
As the Federal Reserve acknowledged the recent tightening of financial conditions, this reduces the need for future rate hikes, but potentially increases the risk of hawkish surprises.
Just as importantly, markets will have to re-price the possibility of Fed rate cuts too early into next year. The onslaught of economic data hasn’t been particularly shocking, and even off the margin, it wouldn’t suggest that the Fed is in a rush to cut rates.
In fact, Wall Street had a subdued start to the week after its best week in 2023. In part, this is because traders expect the Fed to try to counter the recent easing in financial conditions by indicating that it will remain flexible in its policy decisions.
Several Fed officials, including Chairman Jerome Powell, are scheduled to deliver speeches in the coming days. Minneapolis Fed President Neel Kashkari has noted that it may be premature to declare victory over inflation, despite some encouraging signs that inflationary pressures are easing. So plenty of opportunities to push back on the rally.
One problem, however, is that the Fed could become a victim of its own success. Fed officials had been using various forums and public appearances to convey a nuanced message to the market: the sharp rise in long-term US Treasury yields that began in August could effectively replace the final rate hike indicated by the September dot plot. The idea was that the rise in long-term yields could tighten financial conditions, thereby doing some of the work the Fed had intended to accomplish with rate hikes.
And the overt delivery of this message at the FOMC sparked a bond rally, reversing the very dynamic the Fed was trying to achieve. If long-term yields fell and stock prices rose, that would ease financial conditions and potentially negate the justification for skipping the last rate hike.