The Dow Jones Industrial Average, the NASDAQ Composite and the S&P 500, the key US stock market indices, dropped on Thursday. Foreign exchange market was extremely volatile yesterday. Market participants reacted strongly to the US inflation report for January, according to which the indicator accelerated already to 7.5% y/y. The movements of many currency pairs were more like a panic than a logical and appropriate market reaction. The US dollar is no longer rallying on a rise in inflation as it used to. A few months ago, every increase in inflation automatically raised the probability of a key rate hike in the near future. Now, it is absolutely clear to everyone that there will be at least four rate hikes this year. So, it no longer matters how much inflation has risen. The stock market reacted to the same report with a drop, which is quite logical and appropriate. After all, the higher inflation, the higher the key rate could be raised this year. Furthermore, it is now a question of a 0.50% hike at the next meeting. For stock indices and equities any tightening of monetary policy is a negative factor.
This negative factor has been mentioned many times before. However, since the Fed has embarked on a path of monetary policy normalisation, it will be cited frequently. Generally speaking, the stock market has already started to correct and it is likely to be a long process. Notably, February will be the last month when the Fed will be buying mortgages and treasuries under the QE programme. This programme is coming to an end and a sell-off of bonds from the Fed's balance sheet could start as early as summer. These are two more negative factors for the stock market. Therefore, in spite of the quite strong rally of the indices in the last two weeks, we believe that this move was a correction against a global correction. In other words, the decline could resume at this time.
It should also be noted that the members of the Fed's monetary committee are no longer polarised. Almost everyone believes that the rate should be raised at least 3-4 times in 2022. Thus, the outlook for the indices listed at the start of the article is not bright. The same applies to all risky assets, e.g. bitcoin. It has also recovered strongly in the last couple of weeks, but its prospects also depend a lot on the Fed's actions. The next meeting of the US regulator will take place in March, so the indices might stay flat until then. However, if the Fed raises interest rates by 0.5% a collapse could be very possible.
