Federal Reserve Chairman Jerome Powell surprised markets this week with relatively robust support for a quickening of the taper of the central bank's bond-buying program, even though he believes the omicron variant could slow progress in the labor market.
The quickened taper of the Fed's program is likely to continue to bolster the U.S. dollar, push shorter-term Treasury yields further up and complicate the ongoing rally in U.S. stocks.
But surging inflation appears to have forced the Fed's hand, compelling the central bank to prepare for an early end to its $120 billion monthly bond-buying program, with interest rate hikes expected to follow shortly.
"The economy is very strong and inflationary pressures are high, and it is therefore appropriate, in my view, to consider wrapping up the taper of our asset purchases …perhaps a few months sooner," Powell told the Senate Banking Committee Nov. 30.
Fed officials, including Vice Chairman Richard Clarida and President of the Federal Reserve Bank of San Francisco Mary Daly, have publicly supported a faster taper, a push backed by "some participants" of the November meeting of the rate-setting Federal Open Market Committee, according to the meeting's minutes.
"The Fed is clearly saying it's falling behind the curve and is starting to get an itchy trigger finger," said Win Thin, global head of currency strategy with Brown Brothers Harriman.
While an early end to the bond-buying program and a rate hike to follow appears inevitable now, some economists believe the omicron COVID-19 variant may thwart those plans.
"That's the fly in the ointment," said Steven Blitz, chief U.S. economist with TS Lombard, in an interview. "If you believe this variant is going to slow the economy enough and take down inflation near-term, squashing demand … they might not speed up the taper."
The Fed's push to tighten monetary policy sooner than expected has boosted the U.S. dollar, which has rallied to its highest levels since July 2020.
"The [foreign exchange] market remains hyper-focused on monetary policy normalization," said Matthew Weller, global head of research at FOREX.com and City Index.
The dollar is likely to continue to rally against the euro and yen, as the Fed is expected to tighten its pandemic policy faster than other central banks, Weller said.
Divergence in monetary policies of central banks is "unequivocally dollar positive," with the European Central Bank, Bank of Japan, Swiss National Bank and Riksbank all unlikely to hike rates before 2023, and potentially not until 2024, said Brown Brothers Harriman's Thin.
Quicker pace
The Fed is expected to announce it will double the pace of its bond-tapering program to $30 billion per month beginning in January, concluding all asset purchases by mid-March 2022, Jan Hatzius, chief economist at Goldman Sachs, wrote in a Nov. 25 note.
After concluding the taper early, the Fed will then hike interest rates three times in 2022, with the first hike coming as soon as May, Hatzius wrote.
In a Nov. 30 note, strategists with Barclays wrote that they expect the Fed to conclude purchases by mid-April, with the first rate hike in May followed by two more in 2022 and four in 2023.
Market odds for at least one rate hike by June 2022 were at 68% Nov. 30, roughly where they have been for the entire month, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.
Market odds favor at least two rate hikes by the FOMC's November 2022 meeting and at least three hikes by the committee's February 2023 meeting.
Higher rates increase borrowing costs, which boosts savings, slows consumer spending and causes the economy to slow and inflation to decline.
A rate hike this spring is viewed as almost inevitable, as inflation has soared above many economist expectations and the central bank's goal of inflation above 2%. The Fed's preferred core personal consumer expenditure metric was 4.1% in October, the biggest jump since January 1991.
Expectations of a quicker tapering and a possible spring rate hike have caused a rise in shorter duration Treasury yields and a drop in longer duration yields. The 30-year Treasury yield, for example, fell 30 basis points in November, while the one-year Treasury yield climbed 9 basis points.
"A speedy taper amid another wave of COVID means that we will see the front part of the yield curve moving higher and the long part of the yield curve staying underpinned or even falling," said Althea Spinozzi, a senior fixed-income strategist with Saxo Bank. "Short-term yields will continue to rise. However, long-term yields will decline as the omicron variant remains a threat, as growth expectations need to be revised."
The quicker taper and near-term rate hike expectations may also lead to "further weakness" in U.S. equities, said Edward Moya, chief market strategist at OANDA.
The S&P 500 ended November down nearly 3% from its all-time high set Nov. 18.
"If inflation continues to surge and the expectations grow for the Fed to deliver quicker rate hikes because they were wrong with inflation and took too long to taper, you could see a major risk aversion theme that comes with recession fears," said Moya.