[FOMC] US Stock Rally Despite Big Step in 22 Years... "More Dovish Than Expected"

[Image source=AP Yonhap News]

[Asia Economy New York=Special Correspondent Joselgina] "More dovish than market expectations. (Citi)" "The first case recently where no hawkish signals were sent to the market." (Wells Fargo)

The U.S. Federal Reserve (Fed), which has transformed into an 'inflation fighter,' executed a 'big step' by raising the benchmark interest rate by 0.5 percentage points at once for the first time in 22 years and announced quantitative tightening, yet the New York stock market cheered. This was due to Fed Chair Jerome Powell, who has recently been delivering hawkish remarks, clearly ruling out a 'giant step' by stating, "We are not actively considering a 0.75 percentage point rate hike." By drawing a line on 'high-intensity tightening,' the market widely evaluated the move as more dovish than expected.

◆Fed Takes a Big Step, Policy Statement Reviewed

Ahead of the May Federal Open Market Committee (FOMC) regular meeting, market attention was already focused on the next step. This was because Fed officials, including Chair Powell, had already signaled a 0.5 percentage point hike and balance sheet reduction since last month. The monetary policy statement released immediately after the FOMC meeting largely aligned with those expectations.

On the 4th (local time), the Fed announced it would raise the benchmark interest rate from the current 0.25-0.5% range to 0.75-1.0%, a 0.5 percentage point increase. This was the first big step since May 2000 during the dot-com bubble. Additionally, the Fed decided to begin balance sheet reduction starting June 1. It will allow $47.5 billion worth of maturing bonds and mortgage-backed securities (MBS) next month not to be reinvested, letting them flow into the market. This amount will be gradually increased to $95 billion over the next three months. By type, $30 billion in Treasury securities and $17.5 billion in MBS will be sold next month. Subsequently, the amounts will be increased to $60 billion and $35 billion respectively for Treasury and MBS.

The FOMC stated, "Inflation remains elevated, reflecting supply-demand imbalances related to the pandemic, rising energy prices, and broad-based price pressures," and assessed that "ongoing increases in the federal funds rate will likely be appropriate."

The released policy statement added that "overall economic activity edged down in the first quarter, but household consumption and business fixed investment were strong." It also newly included the phrase, "China's COVID-19 related lockdowns may further worsen supply chain disruptions," and that "the Committee is highly attentive to inflation risks." It was also noted that ongoing issues, including Russia's invasion of Ukraine, are contributing additional inflationary pressures.

◆Powell Draws Line on Giant Step, Reviewing Press Conference Remarks

The market's focus was on Chair Powell's press conference remarks. At the first offline press conference since the pandemic, Powell began by mentioning inflation concerns. He said, "Inflation is too high," and "We are doing our best to stabilize inflation."

He also indicated that "there is broad recognition that a 0.5 percentage point increase should be considered at the next couple of meetings," hinting that big steps like the one taken today could continue at the June and July FOMC meetings.

However, Powell drew a clear line regarding the possibility of a sharp 0.75 percentage point rate hike raised by some, stating, "We are not actively considering it." This had been a question of interest since the big step was taken as a given by the market. He reiterated, "A 0.75 percentage point increase is not on the table," and "We will continue to discuss 0.5 percentage point increases."

This was a clear departure from some expectations that Powell might leave room for a giant step to curb soaring inflation. A 0.75 percentage point hike has never occurred since the so-called 'bond market massacre' in 1994, when the Fed raised rates from 3.0% to 6.0% within a year.

Powell said, "While inflation may not decline immediately, it will flatten, and we expect to see more evidence." He also added that there are some signs that core PCE has peaked. When asked if rate hikes could be reduced if inflation falls next month, he replied, "Not in one month," and "We need to confirm that inflation is truly under control and starting to decline." He continued, "Even then, we might return to 0.25 percentage point increases rather than stopping," and "If our expectations hold, we will discuss 0.5 percentage point hikes at the next two meetings."

He dismissed the possibility of a recession. Powell diagnosed, "Our economy is very strong and can absorb the rate hikes we want to implement," and "We believe we can control inflation without causing an economic shock." The forecast that inflation may not fall but will stop rising aligns with this view.

He emphasized, "Solid growth is expected this year," adding, "Although some sectors were relatively slow in the first quarter, household spending and business investment are quite strong, and there are many employment opportunities in the labor market. Wages are also rising." He argued, "There is nothing close to a recession." He projected the U.S. economy to grow steadily at about 2% this year. Additionally, he added, "There is a good chance for the U.S. economy to achieve a soft landing or a gradual landing."

◆Evaluations of "More Dovish Than Expected"

Major investment banks generally assessed that the monetary policy decision centered on the big step and quantitative tightening largely met expectations. However, they diagnosed Powell's press conference remarks as somewhat dovish.

Citi said, "More dovish than market expectations," and analyzed, "It is very surprising that the possibility of a 0.75 percentage point hike was ruled out amid high risks of further inflation increases." This raises the possibility that some Fed officials, including James Bullard, President of the Federal Reserve Bank of St. Louis, may deliver more hawkish remarks in the future.

Wells Fargo also pointed out Powell's remarks ruling out a 0.75 percentage point hike as "the first case recently where no hawkish signals were sent to the market." Deutsche Bank mentioned, "A clear signal that a 0.75 percentage point hike is not actively being considered," and "Although the balance sheet reduction limit is somewhat high, the pace is actually somewhat slower than expected in the long term."

However, even though the giant step was ruled out, the forecast of consecutive big steps was also evaluated as sufficiently hawkish.

Bank of America (BoA) reported, "Powell emphasized the need for rapid normalization and indicated the possibility of two 0.5 percentage point hikes and rates above neutral if necessary," describing it as "a moderately hawkish stance." Nomura Securities, mentioning the recent inflation rise trend, still sees the possibility of a 0.75 percentage point hike.

According to the Chicago Mercantile Exchange (CME) FedWatch, the federal funds rate futures market had reflected over a 90% chance of a 0.75 percentage point hike at the June meeting until the day before, but it has now dropped sharply to 0%. This is based on federal funds rate futures price data estimating the probability of Fed policy changes.

◆New York Stock Market's Relief Rally...Dollar Hits Lowest in a Week

The Fed's tightening announcement did not exceed market expectations, and the New York stock market showed a relief rally. When the big step was implemented as scheduled at 2 p.m. that day, major indices only showed slight gains, but about 30 minutes later, Powell's remarks that "a 0.75 percentage point increase is not actively being considered" became known, sharply expanding the gains.

At the New York Stock Exchange (NYSE) that day, the Dow Jones Industrial Average closed at 34,061.06, up 932.27 points (2.81%) from the previous session. The S&P 500, focused on large-cap stocks, rose 124.69 points (2.99%) to 4,300.17, and the Nasdaq, focused on tech stocks, closed at 12,964.86, up 401.10 points (3.19%). The Russell 2000, centered on small-cap stocks, also rose 51.07 points (2.69%) to 1,949.92.

In the bond market, U.S. Treasury yields turned downward. Particularly, the 2-year yield, sensitive to monetary policy, fell by 0.14 percentage points. The long-term benchmark 10-year yield briefly exceeded 3% that day but slid back to around 2.93%.

Risk appetite strengthened, and the soaring dollar value plunged. The dollar index, which reflects the dollar's value against six major currencies, fell 0.93% from the previous session to 102.5, the lowest in a week. The dollar index had recently shown strength, hitting a 20-year high at the end of last month.

Christopher Smart, CEO of Berings Investment, evaluated, "The Fed's message helped ease investors' anxieties. There is a sense that they are heading in the right direction." Kim Forest, founder of Boke Capital, also said, "It was wise to take the 0.75 percentage point hike off the table, which could have caused concern," and added, "I think it was the cause of the market's relief."