Should this high inflation be confirmed, our turn out even higher than estimated, the market could raise its expectations about a more aggressive reaction from the Federal Reserve regarding a tightening of monetary policy. This could directly influence the dollar’s price, but also treasury bonds and possibly the stock market indices.
In this sense, the statements of Fed member Loretta Mester were very interesting. She acknowledged that the central bank would have to move faster than in the past to exit accommodative policy if it wants to curb inflation that is well above target. However, it may not be necessary to start with a 50-bps hike, but Mester didn’t rule out that possibility. She added that all the meetings scheduled for this year – except for the March one – could represent opportunities for rate hikes and that everything will depend on inflation.
On the balance sheet reduction of the Fed, it's a move that should be considered when stating that the central bank needs to move faster to shrink its $9 trillion portfolios. Selling mortgage-based securities might be one of the ways to go about this. If the Fed decides to sell part of its balance sheet in the market - even if they were mortgage bonds - the effect on the market could be greater than a rise of 50 bps, especially for long-term interest rates.
How did the financial markets react?
The markets were largely unchanged after Fed’s comments. The yield on the US 10-year bond remained around 1.95%, while the foreign exchange market didn't move. Only the stock market indices stood out from the rest of the assets showing a bullish move of more than 1% in the case of S&P500 and Nasdaq.
In a scenario of high geopolitical uncertainty and with inflation at the highest levels of the last forty years that threatens to shoot up interest rates, the stock markets' resilience is surprising. This can only be explained by the better-than-expected earnings reports released by some of the market’s biggest companies.
Sources: Bloomberg, Reuters.