US market close: Buy the dip

As Wall Street traders prepare for Wednesday's Federal Reserve decision, stocks showed a strong upward movement, largely driven by gains in a select few major technology stocks. Equities managed to recover from earlier losses, with the tech giants collectively known as the "Magnificent Seven" leading the charge. Nvidia Corp. saw notable gains, with investors betting on the transformative potential of artificial intelligence to drive a market rally.

Crucially, bond markets stabilized following a recent slide, during which traders adjusted their expectations for the timing of future policy easing. This stabilization may be partly attributed to a more dovish stance from the Bank of Japan, which provided less hawkish reassurance for the JGB markets and avoided the dreaded spillover effect into global markets.

Investors are showing minimal apprehension towards the prospect of a "higher for longer" environment and persist in buying dips. This confidence is underpinned by the robust performance of the US economy and the anticipated normalization of inflation levels.

At their meeting this week, investors are closely monitoring whether the Federal Reserve will delay interest rate cuts in response to recent strong inflation figures.

However, the Fed is concerned about a more vexing issue: the risk that postponing rate cuts could inadvertently trigger a recession.

While recession risks may not be explicitly discussed this week, they will likely influence the Fed's decisions in the future, potentially leading to rate cuts in due course.

Following the two-day meeting ending on Wednesday, the central bank is expected to maintain its benchmark interest-rate target of 5.25% to 5.5%, a level not seen in 23 years. All eyes will be on the updated interest rate and economic projections.

In their December projections, most Federal Reserve officials anticipated a decrease in a key inflation measure from just above 3% at the close of 2023 to slightly below 2.5% by the end of this year. They also foresaw three quarter-point rate cuts throughout the year.

However, with inflation exceeding expectations in January and February, investors eagerly await whether officials still maintain projections for three cuts or have revised it to two. Attention will also be on Fed Chair Jerome Powell's press conference for hints on whether the first cut remains feasible in June, as currently anticipated by futures markets, or if it might occur later.

Earlier this month, Powell hinted at the central bank's intention to cut rates by midyear, contingent upon monthly inflation data affirming a sustained downward trajectory. He stated to lawmakers on Capitol Hill, "When we do get that confidence, and we're not far from it, it'll be appropriate to dial back the level of restriction so that we don't drive the economy into recession."

The focus on interest-rate projections during this week's meeting masks a significant shift within the Federal Reserve over the past year, which carries more significant economic implications.

Current interest rates exceeding 5% stem from the Fed's actions when they raised rates to this level in the summer. Back then, policymakers were concerned about the potential for inflation to become entrenched at 3% or higher, well above the Fed's 2% target. The prevailing belief was that the only way to curb inflation would be through slower economic growth and higher unemployment, outcomes expected from higher rates.

However, contrary to expectations, inflation has rapidly decreased despite robust economic output and job growth. Supply chains have stabilized, leading to lower prices for goods.

Fed officials are becoming less concerned about inflation persisting above 3%. Despite a slight uptick in February, inflation measured by the Fed's preferred gauge likely remained below that threshold.

However, the worry is that inflation might take longer to reach the Fed's 2% target. This could happen if services inflation remains stubbornly high and slow to decline or demand for goods rebounds, leading to higher prices. Rather than resorting to rate hikes, the central bank may delay rate cuts in response to this scenario.

Forex

USD/JPY continued its upward trajectory, with limited evidence during Ueda's presser to deter investors from buying USD/JPY. The post-BoJ move suggests that despite concerns about possible intervention, USD/JPY could continue to rise, especially if the Fed's dot plot signals only two rate cuts this year at tonight's FOMC meeting. This reflects the classic 'buy-the-rumour / sell-the-fact' market reaction to yesterday's decisions, with USD/JPY returning close to levels where intervention has occurred previously and JGB yields modestly lower on the day.

Vagueness in central bank communication is a classic tactic that provides greater flexibility. However, Governor Ueda also made it clear that upside inflation risks and/or stronger economic data would warrant additional rate hikes in the future. The BoJ is now essentially data-dependent, marking a significant change in its reaction function and potentially leading to greater FX volatility. This could discourage further accumulation of yen carry positions, especially against the backdrop of rising oil prices and imported inflation.

Oil Prices

Oil prices have continued their steady ascent this week, buoyed by various factors contributing to supply concerns. Ukrainian drone strikes targeting Russian refineries, along with key OPEC+ members agreeing to reduce crude exports in the coming months, have added momentum to the upward trend. Saudi Arabia's decision to decrease exports as it focuses on domestic refining, coupled with Iraq's commitment to cut exports following a period of non-compliance with OPEC+ agreements, has tightened the global supply outlook. Additionally, improving prospects for Chinese demand heading into the summer further support the bullish sentiment, bringing the $90 per barrel mark within closer reach.