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How Deep is your Dove?

Updated: Oct 19, 2021


As we suspected the Jerome Powell’s Jackson Hole speech was not a watershed event. The Fed Chairman broke little new ground, re-emphasizing the Fed’s accommodative stance with no indication of an earlier or faster taper of the asset purchase program. One potential point of interest was the attempt to delink rate expectations from the taper. Recall in the prior cycle the Fed started to hike rates before they actively reduced the size of the balance sheet (chart 1).

The way price responded to news on Friday suggested that no news was good news on the taper. The most likely timeframe is an announcement in September and commencement in November or December. However, the timing is likely to remain dependent on the macro news flow, particularly on the labour market. That outcome has been well-flagged and expected by financial markets. Nonetheless, a positive macro surprise could still bring forward or delay poli- cy normalisation. Moreover, regardless of how well telegraphed, liquidity withdrawal is likely to prove challenging for risk assets.

While the time spent on inflation might indicate what is really vexing the Fed, the Chairman continues to have a sanguine attitude on the potential for a wage/price spiral. From that per- spective, Friday’s personal income data was interesting. It revealed another 1% rise in aggre- gate wage income across the economy, taking it 5.3% above the pre-pandemic peak (chart 2). That is similar to the message from the job openings survey on the demand for labour and in contrast to the supply of labour in the non-farm payroll data. Put another way, it is possible that the underlying strength in the labour market might exert pressure on the Fed later this year or early next year as wage pressure puts more pressure on core inflation and concern about the COVID mini growth scare recedes.

Looking further out, the big picture question is whether a reduction in the Fed’s balance sheet and eventual rate hikes will be disruptive for markets if it is well telegraphed? In the short term, the answer is probably not if accompanied by strong growth and profits. That’s why having a sense of the stage of the cycle is important. However, as the macro and market cycle matures and the Fed normalises policy that will eventually lead to a withdrawal of liquidity and a rise in cross asset volatility (chart 3). Moreover, the longer the Fed delays policy normalisation, the greater the build up in system-wide leverage.

On the positive side, the recent mini growth scare and moderation in Chinese liquidity have reduced expectations and sentiment in non-US equities. Lean global inventory, pent-up savings and consumer demand also probably set up a strong fourth quarter in Asian equities. We also anticipate some fiscal and credit easing in China by year end. A risk to the dovish Fed view would be stronger-than-anticipated recovery in employment over the coming months. That could bring forward the timing and speed of the Fed’s taper and lead to another phase of US dollar strength. In turn, it might prove challenging to our constructive view on EM/Asian assets although risk compensation is considerably better than in US equities.

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