Traders are taking caution in their positioning today as they look ahead to a potentially ground-breaking announcement following the meeting of the Federal Reserve’s FOMC. There are three main factors to consider: timing of the next rate hike; balance sheet reduction; and changes to the economic forecasts.
Will they hike in September? There is no expectation of a hike today, and certainly not if they announce to beginning of balance sheet reduction. The Fed has been more cautious recently and they would not engage a potentially double hawkish move.
Will they hike in December? Fed Funds futures show expectation is currently around a 50/50 chance of a hike in December. Watch the 2017 central dots, if they move from a 1.4% average then the move becomes questionable again.
The “dot plots” are key
This will be a key factor, currently the expectation is:
Forecasts for 2018/2019 will be interesting as the market is currently pricing just one hike in 2018.
However the lack of inflation is a key factor and FOMC officials are concerned it is taking longer than expected for it to return to the 2.0% target (look at the FOMC inflation projections for this too). This could be a driving force behind a shallowing of the rate hiking cycle. With several FOMC members referencing the lack of inflation (Kaplan and Brainard esp) the dots could therefore begin to come down. If this terminal rate is reduced from 3.0% then this would be seen as a dovish move and the yield curve is likely to flatten in the near to medium term.
Balance sheet reduction
The speeches of even the more dovish members of the FOMC such as Lael Brainard have been suggesting balance sheet reduction will be announced this month. The Fed has found the balance sheet swollen to $4.5 trillion following its succession of quantitative easing programs. This has helped to pull yields lower and support asset prices. Fed economists have suggested that the impact of QE has been to drive down the 10 YT yield by around 1% and the wind down could have the reverse impact. The Fed will therefore try and downplay this as much as possible, but the impact of this should be to tighten the longer end of the yield curve.
However, the balance sheet reduction will be very slow. It will take 8 years to offload its Mortgage Backed Securities portfolio. But also the amount of the reduction of Treasuries will depend on what the size of the balance sheet the Fed wants to end up with. This is something that perhaps a new chairman will answer (Yellen’s tenure is up for renewal in February) but with so many changes in the FOMC in the coming months (with Stan FIscher’s resignation in October there are five positions up for grabs) it is unlikely we will know until well into next year. If Trump packs the FOMC with hawks then the balance sheet reduction could be faster and larger than previously thought. This would send yields higher in the longer term but the impact in near term is likely to be only gradual.
It is expected to announce that it will slow the amount of monthly repurchases by $10bn which will then be stepped up after three months. It will ultimately become $30bn per month of Treasuries and $20bn per month of Mortgage Backed Securities. Treasury wind down can be predicted by the maturity date, but the MBS portfolio shrinkage is less predictable due to intricacies of the housing portfolio. This wind down has been telegraphed already so could have little real impact, not to mention the fact that it could take years to unwind the huge distortions to the bond market.
Inflation/Economic growth trend
Although the headline CPI increased to +1.9% (from +1.7%), core CPI is stuck at +1.7% and core PCE is +1.4% and not moving. The Fed would surely want to see at least two data points on PCE picking up to argue that the 2017 decline is merely “transitory”. It will be interesting to see the Fed’s assessment of the impact on inflation of the persistent low core PCE (currently not budging from +1.4%) and the impact of the hurricanes.
As for growth, the US data remains mixed, however it was interesting to see the Atlanta Fed’s GDPNow model falling to just 2.2% for Q3 (from 3.0%) following the disappointing retail sales and industrial production numbers. Add in the impact of the hurricanes and this could impact what the Fed says, even if the impact is temporary…
Our expectation is that the market will not react on the balance sheet reduction. More focus will be given to the dot plots. With this in mind a reduction in the dots could pull yields and the dollar lower at least for the near term.
Market impact of this