Powell Preview: Three scenarios for the Fed to defuse the bond bonfire, market implications

Calm before the storms – markets found some solace, but it hinges on new soothing words from Federal Reserve Chair Jerome Powell. While the world's most powerful was testifying before Congress, stocks held up. However, Thursday after his testimony, all hell broke loose with bonds and stocks sinking in tandem, placing the dollar back on its throne.

King Dollar has since edged lower as markets await another speech by Powell – his last public appearance before the Fed's "blackout period" leading to its rate decision. How will he shape expectations?

Investors remain worried about potential rate hikes due to rising inflation – a result of fiscal stimulus serving as fuel on the fire of a vaccine-led recovery. The FDA's approval of Johnson and Johnson's single-shot jab and the Senate's discussions of President Joe Biden's covid relief package serves as a reminder of these two themes. 

How will markets react? Here are three scenarios:

1) Same-same – dollar resumes gains

Powell may stick to his previous script – saying that any inflation will likely be transitory and that there are still ten million Americans out of work. More importantly for markets, if he says that higher yields are a healthy sign of better growth prospects, he would give bond vigilantes a green light for another sell-off. 

In this case, higher returns on US debt would sink stocks, as rich multiples on earnings would seem less attractive, while the dollar would become more appealing with higher Treasury yields. 

2) Watching closely – soothing stocks, but not the dollar

The Reserve Bank of Australia has already intervened in markets and scooped up the debt of the land down under in order to lower yields. The European Central Bank and the Bank of Japan have settled for warnings, but they seem itching to act. 

If the Fed joins the fray – but without hinting at imminent action – it would show that the Powell Put is alive and kicking. The saying that the "Fed works for Wall Street" would be brushed up and investors would be able to buy stocks given assurances that the bank would not tolerate a crash.

However, for the dollar, it would be insufficient. The Fed would still lag behind its peers in pushing down long-term borrowing costs – "losing" the currency war. The world's reserve currency would be able to resume its ascent – which would make sense amid America's strong recovery.

3) More QE? A Double-edge sword

If Powell is deeply concerned with the potential of another crash in stocks – or higher borrowing costs that would derail the recovery – he could hint of going the Australian way and buying more bonds. That would top up the whopping $120 billion / month already in place. 

In that case, clues of printing dollars would sink the greenback. Contrary to responses in the euro and the pound to creating new currency out of thin air in 2020 – surprising rises – more Fed printing is adverse for the greenback. 

How will stocks react? While markets tend to cheer more money, an initial upward swing on Wall Street could be followed by fresh concerns of inflation. If investors see Powell as going too far with QE, they could also quickly change their mind and see the bank forced to reverse course. 

Back in 2018, markets tumbled when Powell raised borrowing costs for the fourth time, causing a crash around Christmas. In early 2019, he already changed tune and began slashing rates – well before the world learned about covid. 

Conclusion

Powell has a tough balancing act amid growing uncertainty and jittery markets. His speech on March 4 has three paths mean different directions for stocks and the dollar – with volatility being one of the only certainties. 

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