The Federal Reserve’s FOMC has announced its latest monetary policy and markets have taken it as a hawkish move. Treasury yields have pulled higher and the US dollar has strengthened. What has driven the move and will it continue?
On monetary policy, as expected the Federal Reserve has not moved to hike for a third time this year. Rates were held at a range of 1.00% to 1.25%. However they did announce the beginning of the balance sheet reduction. There were no surprises in the pace of the reduction which will begin at $10bn per month ($6bn of Treasuries and $4bn of Mortgage Backed Securities) running up in increments of $6bn and $4bn respectively on a quarterly basis up to a total of $50bn ($30bn Treasuries and $20bn of Mortgage Backed Securities) by the end of 12 months. This move was well touted previously in the June meeting and is not really the market mover.
However the real reaction has been on the Fed projections and dot plots. The projections for growth were revised higher, whilst unemployment is seemingly an increasingly irrelevant number. Full employment in all but name.
Firstly, the December hike is all but nailed on now. Given that this is the final set of dots before that December meeting, the fact that only four are suggesting no hike (out of a total of 16) there would need to be a significant deterioration for a December hike to now not happen. However, the dots also show that 11 of the 16 members see three rate hikes in 2018. This is a surprise given the focus on inflation that has been reduced for 2017 to 1.5% (from 1.7%) on core PCE and 1.9% (from 2.0%) in 2018. This suggests that the Fed is adamant that it needs to normalise monetary policy no matter what. Is it increasingly looking past the inflation data?
However another interesting factor is that the longer run on rates has been reduced to 2.75% from 3.0%. What is also intriguing in that as the dots go further into the future they become increasingly widely spread. This comes with 2020 with the dots ranging from 1.125% to 3.875%.
Given the longer run hawkish implications of the balance sheet run off, in addition to the dots for 2017/2018 remaining in place (seemingly ignoring the issue of inflation), the market has taken this as a hawkish meeting. So far the cut in the terminal rates has not been an issue. Although it is interesting to see the 2s/10s spread falling.
Market reaction has been strongly dollar positive driven by jumps in Treasury yields. However it is interesting to see that whilst the 10 year yield is 4 basis points higher to 2.28%, the 2 year yield is up by 5.5 basis points. This is pulling the 2s/10s spread lower, i.e. flattening the yield curve. The market is still clearly thinking about that inflation issue.