The continuity trade at the Fed, Jerome Powell gets re-hired

It’s been a busy start to the week with news earlier on Monday that the US President Joe Biden had nominated Jerome Powell to serve a second term as chair of the Federal Reserve. The other contender was the slightly more dovish Lael Brainard, who is now tapped for the role of vice-chair. This is seen as a vote of continuity for the US economy and comes at a moment where the US government is starting to express concern about the speed of price increases and is taking steps to try and reduce price pressures, for example the expected release of some Strategic Petroleum Reserves later this week. The announcement is also a sign that the Fed is likely to hike interest rates in the middle of next year. While the renomination of Powell is mostly good news for financial markets, there was a risk-off tone to financial markets at the start of the week as US Treasury yields took a leap higher, the 2-year Treasury note rose by 8 basis points to 0.59%, the highest level since March 2020. 

Why the FTSE 100 could become the post Covid trade in 2022

The initial response from the market to Jerome Powell’s re-nomination was a stronger dollar across the board, and higher stocks. However, risk sentiment faltered as the day wore on. The Vix volatility index rose as US Treasury yields surged higher during Monday’s US trading session. The dollar maintained its strength and was the big winner from this news. The dollar index rose 0.5%, its highest level since July 2020. EUR/USD weakened by a similar amount sending this pair to below $1.1240, the lowest level since summer last year. GBP/USD also declined by 60 basis points on the back of this news. We think that the euro is likely to come under further pressure this week, firstly on the back of a rising interest rate differential between the currency bloc and the US and the UK, but also because of the fourth wave of covid infections that are ravaging parts of Europe. Austria has already been locked down and German ministers are warning that they will make vaccination mandatory which is likely to spark protests across the country. It is worth noting that vaccination rates in Germany, Austria and elsewhere on the Continent are significantly lower than the UK. Added to this, the UK has a head start on the drive to give people booster jabs, which could also protect the UK economy from another lockdown. Thus, right now, European stocks are at risk due to the impact of this latest Covid wave, whereas this winter the UK’s FTSE 100 could be seen as the post-Covid trade and it may well benefit at the expense of its European peers. 

Powell, Treasury yields and tech stocks 

Back to the US, with continuity at the Fed now assured, it’s a good time to assess what the Eurodollar futures market is doing, and what it can tell us about market expectations for US rate hikes in the medium term. There are currently two US rate hikes priced into the Eurodollar futures contracts for 2022, with a total of five 25bp rate hikes priced in between December 2021 and December 2023, prior to the Powell news, there was a 70% chance of a sixth hike in 2023, which is approximately 143 basis points of tightening currently priced into this cycle. While this is not a typically large increase in interest rates over the course of a hiking cycle, it reflects a Fed that is likely to maintain its view that inflation will be temporary. However, there is a risk that the amount of tightening needed will have to rise, especially if inflation hangs around for longer than expected. Also, 143bps is likely to be tough on tech stocks, which have been a key driver of the S&P 500’s strength this year. As you can see in the chart below, the Nasdaq has actually outperformed the S&P 500 in 2021. However, with the 10-year Treasury yield breaking the 1.6% resistance level on Monday, tech stocks crumbled, and the Nasdaq fell 1.3%. If we see continued increases in US Treasury yields, then we would expect further declines in the tech sector, which could make it hard for the S&P 500 to maintain the strong gains and record highs that it has reached in 2021. This is why we think that 2022 could be tougher year overall for US stocks.

Santa rally a go-go 

We would add a caveat to our view that US stocks could come under pressure next year, typically, US stocks perform well on Thanksgiving week and it usually precedes the “Santa rally”, where stocks markets perform well into year end. Added to this, there was some good news in relation to the supply chain crisis and there are signs that the supply chain crunch is finally easing. The Drewry World Container index has fallen 12%, which measures the cost of transporting a cargo ship across eight East – West routes. Added to this, Ford and General Motors have seen improved flows of semiconductors, while large retailers like Walmart have said that their inventories are strong going into the holiday season. Thus, after today’s risk-off tone in financial markets on the back of the shift higher in Treasury markets, the economic fundamentals continue to be supportive of a Santa rally in the coming weeks. 

Two economic data points to watch 

While the news about Jerome Powell dominated headlines on Monday, we would point out that his nomination still has to be approved by the Senate. We think that this will pass without a problem, as it is likely to please Republicans in Congress since Powell is a Republican. Added to this, the progressives in the Senate who dislike Powell probably do not have the votes to get him kicked out, which is one reason why President Biden chose Powell in the first place. But more important to the Fed chair, aside from his latest nomination, is the PCE data that is released on Wednesday. This will be the last bit of substantial data before the Thanksgiving holiday in the US. The market is expecting the MoM rate of increase for October to rise by 0.4% on the month, with the annual rate of core PCE rising to 4.1% from 3.6% in September. While this is a slower pace of increase compared to US CPI, it is still enough to spook the Fed, and if the PCE increases more than expected then there could be further upward pressure on bond yields and the dollar this week, it could also be bad news for the tech sector. 

Elsewhere, the preliminary October PMIs for November are released on Tuesday in Europe, the UK and the US. Europe could see sharp declines in the November survey data due to new covid restrictions, the UK’s indices are also expected to moderate albeit from high levels. The US is expected to see increases in its service and manufacturing sector PMIs for this month, which would add to evidence that the US economy has sped up in Q4 after a dip in Q3. If the US PMI data does show an increase for November, then this could be another driver of a Santa rally in the coming weeks. 

Chart: S&P 500 and Nasdaq