So it is a mildly more hawkish hike of 25 basis points by the FMOC than some had expected. Or is it? The yield curve has continued to flatten as the market has concerns over falling inflation. The market had expected increasing by 25 basis points to a Fed Funds target range of 1.00% to 1.25% but that is not the real story. Despite falling inflation, the FOMC had no change to the dots and lots of information on the balance sheet reduction plans makes is perhaps more hawkish than the market had expected. Shorter end US yields are mildly higher and the dollar has tiked higher, but this dollar strengthening does not look convincing.
Moving into the meeting, the Fed Funds futures according to CME Group FedWatch suggested that another hike remains unlikely this year, with just 42% probability in December now. In fact the next hike in rates is not expected until June next year!
Falling inflation is an issue for the Fed but it does not seem to be hampering its tightening program yet. Since the turn of the year, the market has seen a significant unwind in the reflation trade as the Treasury yield curve has flattened. However as core CPI fell to +1.7% today (+1.9% expected) the yield on the 10 year fell below 2.129% (last week’s low) to its lowest since 10th November. The Fed is tightening into a market that has concerns over inflation. This is could be seen as a risky strategy. Perhaps this drove one Fed member, Neel Kashkari to dissent.
The dot plots were broadly the same with just a minimal tick lower in 2019 on the rates expectations. However inflation forecasts were strongly downgraded to 1.7% on core PCE for this year (from 1.9%).
The detailed nature of the Fed’s balance sheet reduction was more than the market had expected though. Expected to start this year (if the economy allows) the gradual ramp up in the run off of bonds is expected to reach $30bn of Treasuries and $20bn of mortgage backed securities per month within 12 months. This means around $600bn of balance sheet reduction per year by 2019. This would equate to just over a 25 basis point hike per year.
Market reaction has been to drive a degree of dollar strength, however the lack of significant reaction would suggest that the market is taking this as a hawkish move but still perhaps a touch concerned by the potential impact of the lack of inflation (arguably deflationary pressures still). Yields have ticked higher on the FOMC by around 2 basis points on the 2 year, whilst the 10 year is barely changed, leading to a continued flattening of the yield curve (as shown by the 2s/10s spread falling below 80 basis points.