Fed Signals Aggressive Tightening... Global Markets Shaken

US Stock Market Weakness Continues to Korean and Japanese Markets
Fed Signals Hawkish Inflation Response with Rate Hikes
Market Tensions Rise Over Accelerated Rate Hikes and $8.8 Trillion Asset Reduction

[Asia Economy New York=Correspondents Baek Jong-min, Park Byung-hee, Lee Min-woo, Jang Se-hee] On the 5th (local time), the minutes of the December Federal Open Market Committee (FOMC) revealed that the U.S. Federal Reserve (Fed) is expected to take more aggressive actions to curb inflation, plunging global financial markets into turmoil.

The Fed's stance to raise interest rates in March and to begin balance sheet reduction (quantitative tightening, QT) amounting to $8.8 trillion within the year signals a complete shift from economic stimulus to tightening. This is seen as a clear warning to capital markets, including stocks, bonds, exchange rates, and cryptocurrencies, which had been thriving under accommodative monetary policies.

◇ Stock Market and Cryptocurrency Shockwaves... Dollar Strength Likely to Continue = Immediately after the release of the meeting minutes, U.S. Treasury yields surged sharply across the board, including short-term 2-year and 5-year notes as well as long-term 10-year and 30-year bonds. The 10-year yield soared above 1.7%. Rising yields mean falling bond prices.

As Treasury yields spiked, the Nasdaq index, dominated by growth stocks, plunged 3.3%. Cryptocurrency Bitcoin also free-fell to the $42,000 range. As of 9:56 a.m. on the 6th in the Tokyo Stock Exchange, the Nikkei 225 index was trading at 28,961.58, down 1.26% from the previous trading day.

South Korea's stock market was not spared from the U.S.-originated cold wave. As of 10:24 a.m. on the 6th, the KOSPI stood at 2,934.56, down 0.66% from the previous day, and the KOSDAQ was at 991.35, down 1.81%.

Besides the Fed's more hawkish-than-expected remarks, the sharp decline in trading volume compared to January last year also appears to have contributed to the sluggish 'January effect' in the stock market. There is also analysis that the sentiment to secure funds for LG Energy Solution's initial public offering (IPO) at the end of this month has dampened the rally.

Following the Fed's indication of quantitative tightening after interest rate hikes, the won-dollar exchange rate opened at 1,200.9 won, up 4 won. As the Fed's monetary tightening pace accelerates beyond expectations, forecasts suggest that the early-year trend of dollar strength will solidify.

The exchange rate surpassing 1,200 won at the opening price is the first since July 27, 2020 (1,201.2 won). The intraday crossing of 1,200 won occurred for the first time in three months since October 12 last year (1,200.4 won). However, the rise narrowed afterward, and trading continued around the 1,199 won level in the morning.

With the U.S. actually tightening the money supply, the dollar's strength is expected to persist. Oh Chang-seop, a researcher at Hyundai Motor Securities, explained, "Quantitative tightening actually reduces the money supply itself, which acts as a factor strengthening the pressure for dollar appreciation. It is expected to stabilize around the 1,200 won level in the first half of the year, and the dollar strength trend is likely to continue in the second half as well."

The government has left room for intervention if the exchange rate rises excessively. Lee Eok-won, First Vice Minister of Strategy and Finance, stated, "If rapid volatility expansion occurs, we will strengthen efforts to stabilize the market."

◇ Quantitative Tightening Announced Immediately After Interest Rate Hike = The December FOMC minutes released that day hinted at the possibility of the first interest rate hike starting at the March FOMC meeting.

While the Fed's December dot plot forecasted three rate hikes next year, most experts had anticipated increases in May or June. However, according to the minutes, participants mentioned that "raising the policy rate earlier or faster than expected could be justified." Michael Feroli, Chief U.S. Economist at JPMorgan Chase, explained, "The Fed has firmly confirmed a strong pivot toward rate hikes."

The market immediately reflected the Fed's shift. The Chicago Mercantile Exchange's FedWatch tool estimated a 67.8% chance of a rate hike in March, an increase of about 8 percentage points from the previous day.

What surprised the market even more that day was quantitative tightening. Quantitative tightening is the opposite of quantitative easing (QE), meaning the Fed sells bonds it had purchased through QE to withdraw liquidity previously injected into the market.

Shima Shah, Chief Investment Strategist at Principal Global Investors, explained, "Investors expected the Fed to raise rates this year, but they did not anticipate that quantitative tightening could follow immediately after rate hikes, which caused a significant market shock."

The Fed's assets have doubled over two years since the COVID-19 pandemic, reaching $8.7575 trillion as of the 27th of last month. The Fed's asset reduction can be a tool to reduce market liquidity and suppress inflation. The Fed is expected to engage in quantitative tightening by not extending bond maturities or selling bonds in the market. In this case, market interest rates will inevitably rise.

In the past, the Fed attempted quantitative tightening several years after starting rate hikes. After ending the third round of QE in October 2014, the Fed maintained asset size for three years and began quantitative tightening in October 2017. However, this time, quantitative tightening is expected to start immediately in the second half of this year following the rate hike commencement in the first half. According to the FOMC minutes, participants mentioned that the appropriate pace of balance sheet reduction seems faster than previous normalization cases.

The Fed is rushing tightening due to significant concerns about inflation. As of November last year, U.S. inflation reached 6.8%. Compared to the Fed's usual inflation target of 2%, patience is difficult. The New York Times also judged that quantitative tightening could raise long-term interest rates, increasing borrowing costs and reducing demand.

Earlier, Fed Governor Christopher Waller emphasized in December last year that there was no reason to delay quantitative tightening. He said, "If quantitative tightening starts by summer 2022, there will be less need to raise the policy rate significantly." Governor Waller also provided grounds to estimate the scale of quantitative tightening at about $4 trillion.

The stable recovery in employment is also a factor enabling the Fed to pursue early tightening. According to U.S. employment research firm ADP, private employment increased by 800,000 in December, double the market expectation. The NYT also reported that as the labor market rapidly improves, the Fed has shifted its focus to taming inflation. The positive employment situation means there is a consensus to act preemptively before inflation becomes more entrenched.

This content was produced with the assistance of AI translation services.