QT: Not So Cute

By Stefan Koopman, senior market strategist at Rabobank

As the Global Daily has highlighted time and again, inflationary shocks are not only a reality check to the strategy of an inflation-targeting central bank, but also to the power of a government. The growing protests in Kazakhstan are a good example: it started over a doubling of LPG prices after the government lifted a price cap, but quickly spilled into much broader discontent. Grievances against the country’s elites have simmered for a long time and, as we have seen during the Arab Spring, exogenous shocks like a surge in global commodity prices can inflame already unstable domestic situations. A state of emergency has now been declared in central Asia’s biggest oil producer. The government officially appealed to the Russian-led CSTO for help in suppressing the uprising, as the risk of another ‘colored revolution’ rises. The timing is rather awkward for Putin. The troops who would be used for such operations are currently positioned near the Ukrainian border, as Russia tries to obtain guarantees that NATO will not expand eastwards.

Even though this clearly could have serious and widespread ramifications, global markets largely dismiss this as an idiosyncratic risk. The focus was, for admittedly understandable reasons, entirely on the FOMC minutes. Even though the relevant meeting was in mid-December, before Covid-19 cases surged over the holidays, the minutes confirmed that the FOMC does not see omicron as a game changer. Instead, the participants noted “their continuing attention to the public’s concern about the sizable increase in the cost of living that had taken place this year and the associated burden on U.S. households, particularly those who had limited scope to pay higher prices for essential goods and services”. In particular on the first anniversary of January 6, it’s difficult to resist thinking this is not entirely unrelated to what is happening in Kazakhstan… although one could question whether raising the mortgage bill in the form of higher rates really is the solution in this case!

The FOMC already doubled the pace of tapering December and signaled that it would hike earlier and more often than previously anticipated. It now also suggests that it may reduce the balance sheet earlier and faster than last time (which was two years after the first rate hike) through quantitative tightening, or QT. Even though there was some speculation that the Fed could put a quicker move to QT on the table –as inflation is higher, the labor market stronger, and the balance sheet larger than last time– it still seems to be coming as a surprise. Please see here for Philip’s commentary on yesterday’s minutes.

Suddenly seeing balance sheet reduction on the horizon therefore spooked investors. This could very well be the FOMC’s intention: talking up early the prospect of balance sheet normalization is an easy way to tighten financial conditions without actually having to rush into this. It has optional value and provides policy makers space to discover when supply constraints start to ease and to what extent this would then lead to a decline in the price (increases) of tradable goods. Treasuries extended their slump, with yields on the 10-year note reaching 1.74%, the highest since last April. Money markets are now pricing in about a 75% chance of a rate hike in March, up more than 10%-points from yesterday, even though Tuesday’s manufacturing ISM suggested that softening inflationary pressures could nudge the FOMC to not rush into its first post-pandemic rate hike. The dollar benefited from the prospect of tighter policy: as of right now, EUR/USD trades at 1.129. This morning, global equities extended yesterday’s selloff, with multiple-dependent tech shares being among the worst performers due to the increase in yields.

There was a much more limited market reaction to the bumper ADP number, earlier on Wednesday. The payroll services provider reported much stronger employment growth than expected, with 807K new jobs in December. The improvement was widespread, with leisure and hospitality the largest contributor with 246K new jobs. In recent months, ADP has been more upbeat than the BLS report although it has never been particularly useful in predicting Friday’s number. That said, the Homebase employment figures, which only have a very short track record, suggest payroll growth may even top a million. If these two data points are anything to go by, and this is a big if, there’s upside risk in tomorrow’s numbers. Finally, it’s also worth noting that the impact of omicron is likely to affect the January data rather than December.