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Fed meeting, pivot expectations, interest rate transmission mechanism

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U.S. Treasuries had a mixed day and trimmed early session gains as strong job openings and a surprise recovery in construction spending far outweighed any weakness in the manufacturing sector. This spurred expectations that the Fed could continue its rate hike rhetoric with a terminal interest rate of 5% still on the radar. The news that China will reopen has also caused some fluctuations in the markets, but nothing has been confirmed so far. The front end of the curve underperformed as 2- and 5-year bond yields rose 4-6 basis points. Yields on the 10-year bond fell to 4.04%, while 30Y UST yields rose to 4.09%. As a result, the curve flattened. All eyes are on the FOMC decision. While a 75 basis point rate hike may seem like a done deal, Fed guidance on the future policy path will be scrutinized closely for any signs of policy axis.


We will try to capture important details from Powell’s speech. The first and most important detail, of course, is whether the 75 basis point increase is the last rate hike at this level. It will probably be the last and it is possible that the scale will slide to 50 basis points in December. If we get a 50 bps signal, we’ll also need to analyze it as to whether we’re nearing the end of rate hikes. Since there is no projection update at this meeting, the December FOMC dot chart, which reveals the members’ expectations for the federal funds rate, will of course provide more tangible information. Powell is likely to abstain or remain cautious on this issue. Another issue will be QT, we’ll see if details about the sale of the MBS portfolio will come directly from the balance sheet. Of course, the liquidity problem in the treasury bond market and international developments are also important. It may be an interesting detail how the Fed will evaluate the effects such as bond and repo market developments and liquidity situation, events in England, exchange rate and yield interventions by Japan and China. Recently, many central banks other than the Fed have added new tasks to their price stability functions by trying to control the yields and the exchange rate directly and indirectly, and this is of course unusual for the market. Canada has reduced its rate-raising mode, for example, and the problems will escalate if many countries are caught between overly aggressive Fed tightening and the risks of an economic recession.


In summary, the Fed will probably prepare a little more for a 50 bps rate hike in December, the critical point is whether there will be a fluctuation in the terminal interest rate. While Fed pivot prospects have come to the fore due to the slightly more gradual approach, not only have 10-year yields lost momentum, but break-evens are also seeing a decline.


The UK sidelined tax cuts, the unfunded economic package was withdrawn, the Treasury minister and the Prime Minister changed. Volatility in the bond market may continue, while the BOE’s approach to the event will be important at this week’s meeting. Because we are in the period of QT + rate hike this month. The ECB, on the other hand, increased interest rates by 75 bps, but the QT issue is still not clear, and long-term rate hikes are not very likely due to the already pending energy crisis. Raising interest rates above neutral levels is the main strategy of the ECB, but German bonds being the majority in the portfolio makes it difficult to control a widespread spread at this stage. The Italian-German spread is still an important indicator in terms of the validity and risk perception of this transmission mechanism. In terms of BOJ, we continue to monitor the effects of rising inflation, ceiling protection in bond yields and liquidity problem.


If we look at Turkish assets; Expectations for volatility in the lira fell to the lowest levels in two years. One-month implied volatility, an indicator of expected fluctuations, has dropped below 10% this week to its lowest level since July 2020. The currency changes very little. The central bank has warned commercial banks against actions it says undermine the effectiveness of official policies and has asked them to keep deposit rates low. The Central Bank said it has found lenders to offer rates “well above” market averages to lure lira deposits and avoid applicable rules, according to a letter to the Banks Association of Turkey.


Meanwhile, annual retail inflation in Istanbul, a leading indicator for broader consumer prices, rose to 108.77% in October from 107.42% in September. Turkish Statistical Institute will announce inflation data for October on Thursday. We expect an inflation of 4.6% w/w in October, which is equivalent to 87.4% annual inflation. This will be the highest in a 24-year series since 1998.


The Ministry of Treasury and Finance has published a text on 2022 developments and 2023 forecasts on its website. Total domestic borrowing in 2023 is seen as 918.3 billion TL (49 billion USD). In the January-October period, the average maturity of cash domestic borrowing was increased to 68.6 months. In 2021, this period was 53.5 months. In the January-October period, the average cost of fixed-income Turkish lira domestic borrowing was 17.6%, down from 24.6% at the beginning of 2022.


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