Fed May Need to Talk up More Quantitative Tightening to Regain Control of Markets

  • Market Overview
  • Editors Pick
  • The markets are once again testing the Fed
  • The Fed's forward guidance doesn't seem to be working anymore
  • It may result in the Fed discussing further balance sheet reduction to tighten financial conditions.

The recent CPI data has encouraged investors to challenge the Fed's plans to raise the overnight rate above 5%. But the market doesn't seem to care, and rates are dropping across the yield curve following the inline CPI report. The 2-Year Treasury fell to its lowest rate since October and is in danger of dropping significantly.

If the Fed is determined to raise rates as much as they say and keep financial conditions tight, then the market isn't listening and doesn't seem to care what the Fed wants. 

This can only make one think that forward guidance from the Fed is no longer working. The Fed may have to dig into its toolbox to convince the market it is serious and potentially talk about increasing the size of the balance sheet runoff or the outright sale of its Treasury and MBS holdings.

The market knows the Fed is getting to the end of its rate hiking cycle and is fully convinced the Fed will be forced to cut rates in 2023. However, the Fed has consistently noted it planned to get rates to 5% and keep rates high and financial conditions tight for a long time.

However, despite its best effort and hawkish commentary, the market doesn't care. Financial conditions continue to ease, as the Chicago Fed's Financial Conditions Index has fallen back to a level not seen since May 2022.Chicago Fed Financial Conditions Index

The market's latest move to go against the Fed was a sharp decline in the 2-Year Treasury, which fell to its lowest rate since the beginning of October. It is the first show of weakness the 2-year rate has shown in months; in what could be a sign, the market is now starting to price in rate cuts beyond the Fed Funds Futures market.

It will only leave the Fed to talk about its balance sheet as the last option for the Fed to keep rates elevated and the dollar strong enough to keep financial conditions from easing more than the Fed desires.U.S. 2-Year Yield

The market's latest test is to see how far it can push the Fed to keep financial conditions tight. If the Fed is serious, they will need to push back very hard at some point soon, or they will risk losing control of the narrative and where they want the markets to go.

Talking about higher overnight rates has lost its effect, leaving the balance sheet as the next option if the Fed wants to regain market control.

Otherwise, it will indicate that the Fed is OK with financial conditions easing, giving the market the green light to rally more.


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  • Sridhar N Rao @Sridhar N Rao
    Quite a sensible article! Why should the Fed focus only on stock markets? What about the economy, social welfare, etc?
    Like 1

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