Fed taper and market reaction to set the tone for 2022

A trader works on the trading floor at the New York Stock Exchange. The headline risk event has been Omicron in the final weeks of December. Reuters

As we enter the final week of 2021, markets have unsurprisingly traded sideways with a slight bullish bias but lacking any real conviction.

With the previous Federal Open Market Committee signalling a hawkish swing by the US Federal Reserve, perhaps the headline risk event has been Omicron in the final weeks of December with cases on the uptick globally.

Current pricing action around this variant’s developments would suggest that markets have come to terms with the surging cases and seem to have priced in the effects of its transmissibility. The longer-term effects it could have on global lockdowns and supply chain disruptions (if any) remain to be seen at this juncture.

On the whole, amid a weak economic calendar, it seems we may have a Santa rally after all.

US stock markets have bounced back after a torrid first half of December. After falling close to 5 per cent, the Nasdaq has since recovered to trade slightly positive month-on-month at the time of writing. The gains in the S&P 500 index have been more resilient – after dropping 2 per cent, the index has reversed to post a monthly gain of 3 per cent.

History would suggest that this Santa rally is set to continue. Over the past 92 years, the S&P 500 Index gained 77 per cent of the time during these nine-day trading sessions (seven trading sessions in December and two trading sessions in the new year), according to Sundial Capital Research.

With lighter liquidity during this time – as a result of less institutional buying and selling – retail participation is currently the main driver of risk sentiment.

After a defensive end of November and early December in the lead up to the final FOMC meeting, I sense that retail participation will continue to keep markets trading sideways with a slight bullish bias during this period, before we look to the middle of January where an actual trend will form.

With the Fed clearly in a position to be more aggressive towards rates and tapering, I find it difficult to say that we have seen the full fallout in markets.

Amid a historic two-year period in which the US central bank doubled the assets on its balance sheet, how it unwinds this massive programme has been a topic on many analysts’ minds. As we approach 2022 and the Fed begins to handle this unwind, a full and broad reaction could be in place for equity markets.

Of course, the resurgence of the pandemic will complicate matters further but how the FOMC handles this taper – and the markets’ reaction to this in the early parts of 2022 – will establish the trend for the year ahead.

Looking at currency markets, the weakness in the US dollar arrested some of the losses experienced in November. The EUR/USD currency pairing on the Dubai Gold and Commodities Exchange had a torrid time in 2021. The single area currency dropped more than 7 per cent year-on-year against the greenback.

It was a mixed year for GBP/USD on the DGCX, with the currency losing less than 2 per cent against the greenback. The pound’s resilience can be attributed to a more hawkish Bank of England, which increased interest rates to 0.25 per cent on December 16.

I expect GBP/USD to continue trading in the range between 1.3150 and 1.36 in the first quarter of 2022.

The prospects for EUR/USD, however, don’t look so encouraging. We are yet to see any concrete action from the European Central Bank, which has left the door open to further easing or tapering. This uncertainty will continue to weigh on the euro’s prospects during the first quarter of 2022.

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