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Fed may start pandemic QE tapering by Q1-2022 and rate hikes from Mar’23

calendar 13/01/2021 - 05:55 UTC

USDJPY jumped almost +0.97% in Jan (till 11th) on hopes of Bidenflation. The U.S. 10Y bond yield is now trading around +1.173%, at pre-COVID levels and almost 3.75 times from the Mar’20 corona lockdown panic low of +0.318%. The market is now gradually discounting higher fiscal stimulus under Biden admin, higher economic growth & inflation, and higher real rates coupled with Fed’s QE tapering/normalization in the coming days.

The Fed is now indicating QE tapering after Dec’21 as, by Mar’22, both sides of the Atlantic (U.S.-Europe) should achieve significant herd immunity against the invisible enemy (COVID vaccinations & natural infections), and the society/economy should operate almost normally. The Fed will watch core PCE inflation, which is although now hovering around +1.38%, much below Fed’s primary target of +2.00%, the actual core PCE index is hovering around 114.05, at a lifetime high. At the same time, the U.S. average wage is also now hovering around $25.09/H, almost at a lifetime high.

U.S. Wage

The Fed has already hiked/changed its inflation goal post (target) virtually to +2.50% (?) as compensation (catch up) for previous ‘failure’ to achieve the 2% target except mid-2018. The Fed knows that due to supply chain disruptions for COVID (2020) and Trump's trade war policies (in 2019), price/inflation is bound to go higher.

U.S. core PCE inflation rate

U.S. core PCE index

The Fed will now focus on the U.S. unemployment rate; i.e. it will go for gradual normalization (QE tapering and rate hikes), once it gets confidence that the U.S. core PCE is inching towards/above +2.00% (at least) and the unemployment rate falling towards/below 4%. But as Fed has kept its specific levels of maximum employment (minimum unemployment) rate under its discretion (without any specific definition/levels), the Fed may act even if the unemployment rate does not fall below 4% in the coming days. In Dec, the U.S. unemployment rate was around 6.7%.

The Fed may act even around 5% unemployment levels if it feels that under the evolving economic conditions (post-COVID), 5% is the maximum employment level for the U.S. economy, not 4%. In brief, the Fed has kept its option quite open for pandemic policy normalization as per its discretion, not any specific definition to keep the U.S. economy in a goldilocks situation by ensuring maximum employment with price stability.

U.S. Unemployment rate

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The US economy cut 140K jobs in December, well below market expectations of a 71K addition. It is the first drop in employment since the job market started to recover in May from a record 20.787 million loss in April. Employment declines in leisure and hospitality, private education as-well-as government. But job losses were also partially offset by gains in professional and business services, retail trade, construction, and transportation and warehousing.

U.S. NFP Report

Overall, the consumer-facing service sector cut jobs due to the resurgence of COVID. Government as-well-as private jobs were also under pressure due to the fading of U.S. election boost, which acted as a stimulus for the economy; almost $20B have been spent for the Nov election by two main political parties (DNC & RNC).

In December, nonfarm employment was below its February level by 9.8 million, or 6.5%. In brief, the Dec NFP report was mixed amid soft headline (job cuts) and higher wage growth. The market reaction was minimal as the focus was on politics/stimulus rather than economics. Also, the market is now expecting a better NFP report in Jan’21 amid stimulus and PPP checks (grants-CARES Act 2.0). The market is further expecting the CASH Act ($2000 stimulus checks) and CARES Act 3.0 along with significant herd immunity (COVID vaccinations and natural infections) by Mar’22.

U.S. NFP job addition

U.S. Continuing jobless claims

U.S. COVID PUA claims

 Bottom line:

The Fed will watch primarily the corona curve for its QE tapering and subsequent gradual hikes. The U.S. COVID curve (reported active cases) is still far from the flattening process. But it should start to flatten by Dec’21 and by Mar’22; there could be a visible flattening due to mass-vaccinations and natural infections. By then, the U.S. unemployment rate should also fall below 5% and core PCE may advance towards 2%. Thus, the Fed may start its gradual QE tapering from Jan-Mar’22 and may also start to hike rates from Dec’22- Mar’23 and ECB may also follow the Fed, at least in pandemic QE tapering.


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