Markets React to Powell's Hawkishness

The US dollar index (DX) hit a three-month high on Wednesday, March 08, after gaining 1.3% on Tuesday. The move was in line with a spike in US treasury yields following Federal Reserve Chair Jerome Powell's remarks before Congress, where he noted that the Fed was likely to hike interest rates more than markets expected. The rates markets now reflect a potential for hikes to reach a terminal rate of 5.5%. 

Fed Chair Warns of Stubborn Inflation

Federal Reserve Chair Jerome Powell made his congressional appearance before the Senate Banking Committee on Tuesday, in which he warned of the problem of inflation remaining stubbornly above the 2% target. He mentioned that the latest economic data from January was better than expected, suggesting resilience in the US economy and an uptick in inflation. As a result, markets were quick to price in a higher terminal rate than anticipated as the Fed Chair revealed that the Fed would "stay the course until the job is done".

He added that the FOMC could decide to increase the pace of rate hikes if the "totality" of the economic data warranted it. Consequently, this was seen as opening the door to a return to the 50bps hikes at the Fed’s next meeting on March 21-22. Analysts point to these comments as affirming the faster and longer tightening cycle narrative. (Source:Yahoo Finance)

Recession Fears Grow After Powell’s Testimony

On Wednesday, the yield on the 2-year treasury note rose as high as 5.04%, the highest level witnessed since 2007. Analysts point to a similar dynamic from the early 1980s when aggressive interest rate hikes were used to bring down inflation at the cost of producing an extended recession. As a result, the odds of a recession are seen as growing following Powell's comments.

Furthermore, stocks had a sharp sell-off on Tuesday in the wake of the Fed Chair's testimony as the USA 30 - Wall Street (YM) fell by 1.7%, the US 500 (ES) closed down 1.5%, while the US-Tech 100 (NQ) lost 1.2%. The Dow's drop was enough to push the index into negative for the year.

Odds for a 50bps Hike in March Shift

The comments of the central bank’s  Chair before the US Congress raised expectations for short-term rates higher. Traders expect an almost 70% chance of a 50 bps hike when the FOMC meets later in March. That compares to a 30% chance in the survey only a day before. Futures now imply rates will peak above 5.6% and hold at or above 5.5% for the remainder of the year.

The Fed had previously suggested that rates would rise to a range of 5.0%-5.25% this year. But analysts say Powell's hawkish comments imply that rates will rise above that level. Currently, the interest rate is in the 4.5%-4.75% range. Senator Elizabeth Warren raised concerns about how increased interest hikes could lead to job losses, but Powell argued that all Americans are suffering from high inflation. Moreover, Democrats have concerns that the Fed will tighten monetary policy too much. In response, Powell maintained that core inflation to the Fed's 2 percent target would require softening labor market conditions.

The spread between the 2- and 10-year treasury yields is seen as one of the most reliable gauges of an impending recession if it falls into negative territory. Following Powell's remarks, this indicator fell into negative triple digits at 103.7 basis points. That's a level not seen since September of 1981, under then-Fed Chair Paul Volcker.

Traders seem to have a laser focus on the upcoming release of  US employment data on Friday and next week’s inflation figures. Analysts suggest that if those data prints were to exceed expectations, it would be seen as a guarantee that rates would go up by 50bps at March’s FOMC meeting. If the data comes in above forecasts this month, it could substantially boost the dollar.

Closing Remarks

In giving his first day of testimony before Congress on Tuesday, Federal Reserve Chair Jerome Powell said that rates were likely to rise more than expected, and the Fed could increase the pace of the rate hikes depending on the data. Immediately after, traders priced in a significantly higher chance of a 50bps hike at the next FOMC meeting, with the focus now turning to the jobs data to be released on Friday.