Why the Fed’s hawkish tilt will drive market volatility

It has been a tempestuous start to 2022 for financial markets and we can expect more of the same as we head into the second half of January.

Expectations of monetary policy tightening against a backdrop of higher pricing pressures have resulted in the US Federal Reserve coming out with its most hawkish rhetoric yet. This has led to an increase in market volatility over the past few weeks.

US inflation pressures in December peaked at more than 40-year highs, data showed. The US consumer price index (CPI) – a measure of a weighted average of prices of a basket of consumer goods and services – increased by 0.5 per cent a month from November and by 7 per cent compared with a year ago.

The news only reinforced sentiment that the Fed will look to raise rates three times this year, with the first increase expected as early as its meeting in March. This confirmed the hawkish tilt by the Fed, which has all but dropped its “transitory inflation” lingo – the driving theme in 2021.

The effect has been felt in US stock markets. At the time of writing, the Dow Jones index was trading 1.5 per cent lower on the month while the S&P 500 index was lower by 2.55 per cent and the tech-heavy Nasdaq was down by more than 5 per cent.

Traditionally, stock market volatility increases during high inflationary periods and growth stocks generally tend to be hit harder, compared with value stocks, as a function of higher prices eroding current cash flows, which are lower in the latter.

As we look ahead, we do not expect too many comments from the Fed in the run-up to its meeting on January 26.

I expect the turbulence to continue as we enter into the fourth-quarter earnings season. Amid higher-than-expected earnings, cyclical stocks should outperform their technology counterparts, in line with the earlier explanation.

Looking at the currency markets, the euro and the British pound have, thus far, turned in a positive performance against the US dollar this month.

The British pound benefited from the Bank of England’s interest rate increase last month. Technically, the sterling has looked to test the channel above 1.3750, which should then expose 1.40 levels.

Fundamentally, there is a lot of key data coming out on the UK calendar this week but all focus will be on Bank of England governor Andrew Bailey’s views on future rates when he is due to speak on Wednesday.

The euro moved higher against the US dollar, trading above 1.14 on the Dubai Gold and Commodities Exchange (DGCX). I expect any further upward momentum to cease at 1.15 levels.

Commodity markets have performed well through the start of the year, headlined by strong crude oil prices.

The DGCX’s West Texas crude intermediary contract moved above $83 a barrel for the first time in two months and looks to test the more than seven-year high established in November 2021, above $85.

Finally, volatility continued in gold – prices have gyrated between $1,780 and $1,830 this month. With volatility expected to continue, look for this range to widen, with support coming in at the $1,740 level and upper resistance set to kick in above $1,870 on the DGCX.

Looking ahead, along with the Fed meeting on January 26, we await European inflation data on January 20 and the Bank of Canada rate decision and associated statement on January 26, too.

US gross domestic product figures will be released on January 27, with the country's economic output expected to have increased to 5.6 per cent quarter on quarter.

Gaurav Kashyap is head of futures at EGM Futures. The views and opinions expressed in this article are those of the author and do not reflect the views of EGM Futures