This month marked the beginning of the end of the pandemic following vaccine authorisation in several countries across the globe. The coronavirus vaccine rollout will brighten the economic outlook for 2021 and beyond as many hope life will return to normal sometime in the second half of next year. However, we are not out of the woods yet, and there is still a lot to be done to address short-term economic risks. These are the challenges monetary policymakers are currently facing, including the US Federal Reserve who meet later today.

Since June, the Fed has been buying $120 billion of government debt, of which $80 billion goes to US Treasury bonds. This policy was intended to stay for several months, but has no specific economic metrics on how to adjust or end it.

Some policymakers and investors fear that the reflation trade happening now could lead to a spike in long-term interest rates, especially as so much debt issuance is likely to occur in the next few months. A sharp spike in long term-yields would increase borrowing costs for corporates at a time when challenges remain high.

US 10-year yields made two attempts to reach 1% in November and December, but none of them managed to break above this psychological mark. That is mainly because investors do not expect the Fed to allow it, either by increasing their asset purchase program or adjusting the current one towards longer maturities.

There are no indications the FOMC will increase the aggregate size of the asset purchase program. At least not at this meeting. However, shifting most of the bond buying to longer maturities may be enough to keep yields in check and financial conditions loose. Should the Fed refrain from taking such steps or suggesting it, could see 10-year yields finally breaking above 1%. That scenario would be negative for equities and positive for the US dollar. However, the impact would hinge on the pace and the magnitude of the move in yields.

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As of the last meeting, expectations were that the Fed funds rate would remain near zero until the end of 2023. Given that a vaccine rollout has brightened the longer-term economic outlook, wouldn’t this suggest an earlier than expected interest rate hike? Possibly. However, any perception that interest rates could move up earlier would be perceived negatively by markets. Hence expect Fed Chair Jerome Powell to stick to his dovish rhetoric.

He is likely to continue urging for fiscal stimulus and given lawmakers may be a close to reaching a deal, he will give that a final push.

Overall, we do not expect big announcements from the meeting today, but there is still a chance we see some volatility in fixed income markets based on decisions related to the asset purchase program. This is where investors need to be focused.

 

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