Markets left wondering as US Federal Reserve shifts focus back to inflation
The Fed’s shift in focus from supporting jobs to fighting inflation has seen markets reassess their bullish assumption this year that the US central bank has their backs.
Investors wiped $50bn off Australian shares and the Aussie dollar hit two-year lows on Thursday, as US stocks and bonds dived and the US dollar soared after Federal Open Market Committee members raised their inflation forecasts and lowered the amount of rate cuts they expect in coming years.
The S&P/ASX 200 fell as much as 2.2 per cent to a six-week low of 8125.7 points and the Aussie dollar dived about 2 per cent to US61.99c after the S&P 500 fell 3 per cent to 5872 points and the 10-year US Treasury yield jumped 12 basis points to a more-than-six-month high of 4.52 per cent.
It was the biggest scheduled FOMC meeting day sell-off in the S&P 500since 2001.
The Russell 2000 Small Cap index dived 4.7 per cent.
The VIX volatility index soared 9.9 points to 25.64 per cent.
Highlighting the fact that the market was positioning for a hawkish pivot from the Fed, the Dow Jones Industrials Average has fallen for 10 consecutive sessions, including Wednesday – its largest losing streak since 1974.
Together with another quarter percentage point cut in the Fed funds target range to 4.25-4.5per cent, the revised interest rate guidance from FOMC members was largely as expected, but there was a distinctly hawkish shift from Federal Reserve chair Jerome Powell in his post-meeting press conference.
“From now, we are in a place where the risks really are balanced and we need to see progress on inflation. And that’s how we’re thinking about it,” he said.
After holding the Fed funds rate target range at a two-decade high of 5.25-5.5 per cent for over a year to fight inflation, the Fed started slashing interest rates in September.
At the time the FOMC said the risks to achieving their employment and inflation goals were “roughly in balance” and that the committee was “attentive to the risks to both sides of its dual mandate”, implying a shift in focus from supporting jobs just as much as lower inflation.
That wording remained in the December FOMC statement, and the removal of 50 basis points of rate cuts from its median projection for 2025 was broadly in line with market expectations, after stronger than expected economic growth and sticky inflation recently.
But a lift in the median forecast for the core PCE inflation measure from 2.2 per cent to 2.5 per cent for 2025 and signs of dissent on the December rate cut decision suggests the bar for further interest rate cuts has been raised. “Today was a closer call but we decided it was the right call,” Mr Powell said.
“We are significantly closer to neutral,” he added.
“We still think where we are is meaningfully restrictive. And I think from this point forward, it’s appropriate to move cautiously and look for progress on inflation.”
GSFM investment strategist, Stephen Miller – a former head of fixed income at BlackRock – said Mr Powell’s press conference suggested the year ahead would prove “challenging” for investors.
“Inflation is sticky, a mercurial President is threatening to implement a controversial – and probably inflationary – agenda, and risk markets are priced for perfection,” he said.
“The big question is whether the Fed’s dilution in the potency of the punchbowl is a harbinger of a more sober assessment of risk markets in 2025.”
IG market analyst Tony Sycamore agreed the outcome of the FOMC meeting shouldn’t have come as too much of a surprise following the recent run of warm US inflation and activity data.
“However, the Fed’s more hawkish tones were not something that risk markets were prepared for just six days out from Christmas and are the catalyst to wash away some of the speculative excesses that flowed into risk assets, including stocks and bitcoin, following the US election,” he added.
Similarly, SPI Asset Management managing partner Stephen Innes pointed to a spike in implied stock correlations as a sign that Wednesday’s selling of US stocks was “indiscriminately fierce” and said the longevity of the sell-off was “questionable”.
“This dramatic one-day event mirrors past market upheavals, like the early August growth scare and ensuing market wobbles, spotlighting recurring snags in trading strategies such as long dispersion trades,” he said.
“Given the sudden surge in correlations, it’s plausible that this day’s severe volatility swings are merely the latest episode in the market’s ongoing drama of risk reconfiguration, likely amplified by year position squaring.”
Mr Innes noted that such market shocks had been magnified by the volatility impacts.
However, others highlighted the “concentration risk” in the US sharemarket.
The so-called Magnificent Seven tech stocks now account for 33.9 per cent of S&P 500 market capitalisation.
So far this year the group has risen about 50 per cent, with market darling Nvidia up 160 per cent.
Still, US investment bank Citi expects a “sharp dovish pivot” from the Fed in the next few months, based on its view that the jobs market will weaken more sharply than expected.
“Updates to the Fed’s summary of economic projections were more hawkish than expected, with just two 25 basis point rate cuts implied for 2025,” Citi US chief economist Andre Hollenhorst said.
“The Fed base case is that the unemployment rate will not rise further, allowing officials to take their time in gently lowering rates as inflation gradually cools from 3 to 2 per cent.
“But the continued softening of the labour market is likely to become even more evident in coming months, keeping the Fed cutting at a faster pace than markets are pricing, with just 50bp of cuts now priced through mid-2026.
“We expect a sharp dovish pivot from Powell and the committee in the next few months.”
To complicate matters, president-elect Donald Trump said he opposed a proposed funding bill and threatened to oust fellow Republicans if they accepted legislation that didn’t include his demands, increasing the likelihood of a government shutdown later this week.
On Wednesday – just days before US federal funding is set to expire – Mr Trump said he wanted lawmakers to include an increase to the debt ceiling in the package, a politically fraught measure that would allow the Treasury Department to issue new debt to pay existing obligations.
“While the latest developments raise the odds of a government shutdown, a protracted shutdown looks unlikely in our view,” said Goldman Sachs chief economist, Jan Hatzius.
“We do not expect a near-term increase in the debt limit. We estimate that a shutdown would reduce GDP growth in the quarter by 0.15 percentage points for each week it lasted and would boost GDP growth by the same amount in the quarter following government reopening.”
More Coverage
Fundamentals underpinning global tech’s market leadership
The tech sector is both a dominant force in financial markets and one whose potential is largely misunderstood by many investors. So how will it shape the global economy?
ASX 200 rises after RBA minutes; St Barbara tanks
Domestic shares closed higher after the release of minutes from the RBA’s last meeting for 2024, which received some support from the IMF overnight. SBM hit with PNG tax bill.