Fed Likely to Cut Rates Despite Inflation Rebound : Impact on Markets

Fed Likely to Cut Rates Despite Inflation Rebound: Impact on Markets 

The Federal Reserve is likely to opt for a rate cut despite the resurgence of inflation, posing a risk of market adjustment favoring dovish policies. While there's a debate on what the Fed should do versus what it will do, it seems evident that increasing inflation should prompt rate hikes, but that's improbable. Instead, pressures on government funding costs and liquidity are pushing towards rate cuts, despite unwelcome inflation.

This week, attention is drawn to the intertwined nature of monetary and fiscal policies. While the Fed meets on Wednesday, the Treasury's Quarterly Refinancing Announcement (QRA) holds equal significance for monetary policy direction. The disclosed borrowing requirements are staggering, indicating a shift from previous norms. This amplifies the realization that the fiscal deficit may not return to pre-recession levels anytime soon, raising term premiums and pressuring longer-term debt holders.

The mix of Treasury's borrowing duration is crucial. Increased issuance of shorter-term debt has supported liquidity in markets. Without this, the market could have weakened significantly. The announcement will clarify if the Treasury will maintain its focus on shorter-term debt issuance, though there are signs of a shift towards longer-term debt issuance.

Current prices make U.S. Treasuries less attractive. Foreign investors are cautious due to various risks, banks are reducing their UST holdings, and multi-asset managers find them less appealing. With households becoming the primary buyers, their inflation expectations play a significant role. Higher long-term yields may prompt the government to borrow more to cover interest costs, potentially undoing previous policies.

A rate cut by the Fed could alleviate pressure on both the government's borrowing costs and risk assets, aiding financial stability. However, such a move may exacerbate structural risks associated with inflation. Nevertheless, amid liquidity concerns, rising funding risks, and electoral pressures, a rate cut seems probable.

In the short-to-medium term, quantitative tightening might be tapered. However, a full-scale easing or yield curve control is unlikely. Financial repression, redirecting private cash flows to public debt markets, could become a prominent policy tool, eroding Fed independence and intertwining government spending whims with inflation and unemployment considerations in predicting the central bank's actions.