The Federal Reserve moves to taper

While the Fed is moving towards tapering, it is doing so reluctantly, forced by elevated and sticky inflation. We expect that the Fed will eventually be forced to bring forward its start to rate hikes. In particular, the White House may be concerned about the impact of elevated inflation on the US election.

The pace of Fed tapering
The Fed indicated that it would start tapering bond purchases at the end of the month to finish the program in June 2022, but pushed back against expectations of rate increases as early as mid-2022. The Quantitative Easing program will be reduced by ten billion dollars in US Treasuries and 5 billion in Mortgages each month.

The Federal Reserve should lose its rear guard action
Monetary policy has different speeds depending on the country considered and how mortgages are financed. In the UK economy, monetary policy works quickly, partly because households have mortgages financed with short-term interest rates. In contrast, in the United States, monetary policy works with a lag of six to eighteen months because mortgages are primarily fixed rates one, but of course this is not the only factor to consider.

Note: it takes time for labor tightness to feed a wage/inflation spiral much like waves slowly and steadily cresting over each other – by which time this regression model would pick it up as happened in the 1970s.

There are sectors that respond faster – primarily those that are high risk with unstable and uncertain cash flows, for example a cheap car manufacturer. They can only borrow over the next few months and are hence very sensitive to moves by the Federal Reserve to increase or decrease interest rates. On the other hand, companies with stable and predictable cash flows, particularly those with high profit margins, can borrow at much longer maturity and hedge with derivatives commodities and currencies sometimes up to two years. That makes them far more sensitive to longer-dated yields and hence bond tapering by the Federal Reserve. Consumer loans on the other hand are very dependent on short-term rates as is borrowing on credit cards and more broadly many forms of leverage used in the financial markets.
The consequence of this is that monetary policy will not moderate much the surge in demand for goods globally with its consequent stretched supply chains, nor the wage inflation spiral. That means that what the Federal Reserve can control is mostly the narrative. As a result, the Fed is likely behind the curve and will be forced eventually to an earlier and more rapid pace of rate hikes, validating market expectations.

What does it mean?

The odds that the Federal Reserve becomes more hawkish suggests short-duration products and diversification across style.

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