At 2 p.m. EST, the only thing the financial world will care about and discuss will be the Fed's [first rate hike in 9 years|epic disappointment]. So for those who still haven't made up their mind about what the Fed's [dovish|non-dovish] rate hike means, here is all you need to know.
First, a list of all the key announcements and public statements that everyone will be parsing at a feverish pace, courtesy of Citi:
The schedule
- 14:00 EST/19:00 GMT: Statement and economic projections
- To be released here: http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
- Statement will detail if anyone dissented to the decision. If so, most likely Evans.
- Expected alongside the statement: Implementation/operation details note released by NY Fed regarding lift-off.
- NY Fed website press releases: https://www.newyorkfed.org/press/index.html
- Adjust the target band: increase overnight reverse repo rate from 0.05% to 0.25bps
- Of primary interest will be the size of the overnight reverse repo facility that the Fed will put in place to pull short rates higher. Citi US
- Rates Strategy doesn’t think it will be unlimited, but a size large enough that will keep short rates from falling below the 25bp floor – and the size could be as high as USD1tn.
- The o/n reverse repo program is meant to be temporary in nature and will be phased out when the need to pull fed funds higher is not needed. It will be interesting to see how long the RRP program will be needed – perhaps till we get closer to 1% on IOER.
- Doesn’t expect changes to size of term reverse repo operations or any further guidance on ending re-investments at this stage
- 14:30 EST/19:00 GMT: Yellen Press conference
- Speech text generally first published on her landing page: http://www.federalreserve.gov/aboutthefed/bios/board/yellen.htm
- If not first there, then here: http://www.federalreserve.gov/aboutthefed/bios/board/yellen.htm
- Watch the press conference live: http://www.federalreserve.gov/mediacenter/media.htm
How are rates hiked in the age of a $4.5 trillion Fed balance sheet? The following Deutsche Bank infographic explains:
Views on the rate path:
Citi Economics believes that the Fed's path of rate increases will begin in December, but will not reach above two percent until 2018.
The second rate increase will likely not occur until mid-2016. The very shallow projected trajectory leaves the policy rate at 1% by end-2016, 1.5% by end-2017, and 2.25% by end-2018. See the tables below.
FOMC considerations via Citigroup:
The FOMC meeting this week is as close to a foregone conclusion as one can get with regard to lift off. However, given that the lift off is a divergence from other advanced economies which are in stimulatory mode, the reaction of rates markets subsequent to the FOMC decision is an unknown. The questions on investors mind are - will the lift off pass through the market without a significant move in the yield curve? Or will the rates curve get unhinged and if so, would it be a trading opportunity? Finally, how will short rates trade post FOMC? We highlight a few things to keep an eye on for Wednesday.
Some dots can move lower:
The “dot curve” has been generally trending lower in the FOMC quarterly meetings where the Summary of Economic Projections is published, as the Fed has had to revise down its inflation projections and push out the lift off date. Since Sep 2014, the median 2016 dot has moved from 2.875% to 1.375% and the 2017 dot has moved from 3.75% to 2.625%. As far as this meeting is concerned, we think that the 2016 dot is less likely to move lower, given that there are only four rate hikes separating the projections for 2015 and 2016. We think that the median dots for 2017 and 2018 are likely to go lower, with 2018 in particular seeming too high at 3.375%. The October FOMC minutes showed that the Fed had discussed the neutral short term rate, with Laubach and Williams being the key proponents of a lower neutral rate. If the notion of a lower than historical neutral rate has gained more widespread currency within the FOMC, then we would expect to see some lowering of the dots further out, i.e. 2017 and 2018. The long run equilibrium rate at 3.5% however could stay unchanged. Note that Kocherlakota, who had submitted a negative dot for 2015 and 2016, has recused himself from the upcoming meeting and the First Vice President of the Minneapolis Fed – Jim Lyon will be attending and submitting projections instead. We think that expectations for a lowering of the dots is already baked in and If the Fed does not lower the dots, we could see a bear flattening sell off, with the 3y to 5y sector most likely taking the brunt of the selloff.
Will there be any dissents? Until now, dissents have been driven by Lacker of the Richmond Fed who has wanted to raise rates for some time. A potential dovish dissent could arise from Evans of the Chicago Fed who in a recent speech said that he favored a later lift off date, even as he downplayed the importance of the actual lift off date. Evans’ concern is on inflation taking longer than expected to evolve to 2% even as his growth forecast for next year is closer to 2.5%. He said that if the market construes an early liftoff as a signal that the Committee is less inclined to provide the appropriate degree of accommodation to get to the inflation goal, then it would be “an important policy error”. Evans will be looking to execute a “dovish hike”.
Operational details:
There will be a separate document from the NY Fed with details around the operational aspects of the liftoff. Of primary interest will be the size of the overnight reverse repo facility that the Fed will put in place to pull short rates higher. We don’t’ think it will be unlimited, but a size large enough that will keep short rates from falling below the 25bp floor – and the size could be as high as $1tn. As the Fed stated in its policy normalization principles in the March FOMC meeting, the o/n reverse repo program is meant to be temporary in nature and will be phased out when the need to pull fed funds higher is not needed. It will be interesting to see how long the RRP program will be needed – perhaps till we get closer to 1% on IOER. We don’t think any changes are likely to be made to the sizes of the term reverse repo operations that have been announced for late December (total size 300bn, start dates Dec 18, 23 and 30 and maturing on Jan 4 and Jan 5). The interest on this is likely to be set a few bps over the overnight repo rate (note that the term repo over last year end was 5bp over the o/n reverse repo rate). Interest on required reserves is also likely to be moved up, along with excess reserves to 25bp. We don’t think that there will be any further guidance on ending reinvestments at this stage. The FOMC is likely to retain the language on maintaining its existing policy of reinvestments.
After the increase in IOER to 50bp, and the establishment of the overnight reverse repo rate at 25bp (an increase of 20bp from the current 5bp level), we think overnight fed funds should trade around 7-8bp over the overnight reverse repo rate, which gets us to about 32-33bp. As with past years, the fed funds rate is likely to fall towards the end of December, before moving back at the beginning of January. See Figure 2 for our expectations of short rates the day after the FOMC.
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Here is a simple 5 point plan from the WSJ for the key things to look for in the Fed announcement and meeting:
1. Ready to Go
There’s little suspense at this point about whether the Fed will raise rates. Atlanta Fed President Dennis Lockhart, a closely watched centrist policy maker, flatly stated last week that he’s “ready for a decision to lift off.” Private economic forecasters surveyed by the Journal see the probability of a rate increase this week at 87%. Futures markets suggest an 83% chance of liftoff as of Monday afternoon, according to CME Group. It’s hard to imagine a scenario in which the Fed would shock markets with a decision to hold rates steady.
2. Gradual Guidance
The Fed’s mantra has been that the precise timing of liftoff matters less than the path for interest rates going forward. Many officials including Ms. Yellen have repeatedly used the word “gradual” to describe the expected pace of rate increases, but policy makers also appear wary of committing themselves to anything like their mechanical tightening tempo of 2004-06. Keep an eye on the policy statement and Ms. Yellen’s press conference for guidance on what will drive the Fed’s subsequent rate increases.
3. Watch the Dots
For more clues about how quickly and how high the Fed will raise rates, check out officials’ projections for their benchmark federal-funds rate in the quarterly chart known as the “dot plot.” As of September, policy makers’ median estimate saw the rate rising to 1.375% at the end of 2016, 2.625% at the end of 2017 and 3.375% at the end of 2018, just below its normal long-run level of 3.5%. That suggested four quarter-point rate increases next year. But with U.S. inflation still running well below the Fed’s 2% annual target, officials might move their dots down and predict a slower pace of rate increases.
4. Out of Step
Richmond Fed President Jeffrey Lacker has dissented at the Fed’s past two meetings in favor of raising rates. He might get his wish this time, but that doesn’t mean the decision will be unanimous. Chicago Fed President Charles Evans and Fed governors Lael Brainard and Daniel Tarullo have all expressed reservations about raising rates and potentially could cast dissenting votes. A dissent by Ms. Brainard or Mr. Tarullo would raise eyebrows because the Fed’s Washington-based governors typically vote with the chairwoman, and none has dissented since 2005. For her part, Ms. Yellen said she “wouldn’t try to stifle dissents, and I would even expect some at critical junctures.”
5. Nuts and Bolts
If the Fed raises its target for the fed-funds rate to a range of 0.25% to 0.50% as expected, it’ll use an array of tools to tighten monetary policy in a financial system awash with cash. The Fed has signaled that the details will be announced in an “implementation note” alongside the usual policy statement, and officials will watch closely to make sure those tools work as expected. “If adjustments to policy tools or administered rates subsequently proved necessary to implement an unchanged policy stance, the implementation note could be revised without altering the [Fed's] policy statement,” according to the central bank’s June meeting minutes.
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Finally for those confused by wave after wave of nonsensical positivity heading into the FOMC's tightening announcement (if it is so good for stocks, why did the Fed keep rates at 0% for 7 years and why did it inject trillions into the market), here is a less than bullish forecast on how things play out from DB's Jim Reid.
In terms of what we should expect from the post-meeting statement today, we don’t expect there to be much change to the opening statements on economic developments and prospects. We expect the Fed to continue to sound relatively upbeat on the US economy, reflecting Yellen’s recent speech and testimony although it is possible that we see a subtle change in terminology around the balance of risks on the outlook for economic activity and the labour market from ‘nearly balanced’ to ‘very close to balanced’ which would reflect Yellen’s recent communiqué. Recent turmoil in markets on the back of commodity prices and US HY could be a reason to keep the current language however. Of particular importance will be just how the FOMC chooses to address the gradualism of rate rises. This may not be explicitly addressed in the statement and instead driven home at the press conference. It’s likely that Yellen will point to her summary of economic projections and dot plots to help guide this. On the forecasts first of all, we don’t expect there to be much change to the FOMC’s median economic projections for real GDP growth, unemployment and inflation. Saying that, DB’s Peter Hooper believes that recent developments in markets mean the risk to a downward revision for core and headline PCE forecasts may have risen for this year and next. In the event of a downward revision in the inflation projection, a small downward revision to the median interest rate forecast path would be justified (i.e. reducing the number of increases in 2016 from four to three, and reducing the terminal rate. Peter points out that in his view even if inflation and growth forecasts are left unchanged, the dots could be moved lower for several reasons;
- The somewhat softer tenor of key inflation indicators, including inflation expectations, commodity prices, and the dollar.
- A case can be made for further reducing the estimated neutral level of the fed funds rate in the longer run.
- Likelihood of the Committee leadership wanting lift-off to be accompanied by a relatively dovish message about the ensuing path of rates and so narrowing the gap between market and Fed expectations a bit in the market’s direction would help with the digestion of liftoff.
Our US Economics team expect the 2016 and 2017 median dots to remain at 1.38% and 2.63% respectively and instead think the likeliest year for a decline in the median forecast is 2018 (3.38%) which could fall either 12.5bps or 25bps. They also expect the longer term funds forecast to come down by 25bps. Whatever happens this will likely be the key focus for markets, no change to the dots would raise the argument of the FOMC undermining a verbal message on rate hikes being a gradual process and so it would be no surprise to see markets take this negatively.
Good luck to all.