With the market already pricing in dramatically fewer rate-hikes that the "cheerleading" Fed, Deutsche Bank expects the USD to respond favorably to the FOMC’s signals on Wednesday, contrary to the pattern seen after the last four FOMC meetings with press conferences.
The waning influence of the Fed’s projections is showing up in derivatives markets. After the December revision to the projected path of interest rates, traders responded much less than they did earlier in the year in the market for derivatives known as overnight-indexed swaps.
But, as Deutsche's Alan Ruskin notes, the likely comment on the balance of risks will be one indication that all upcoming FOMC meetings are "live." Among the conundrums facing the Fed, are how much weight to place in the predictive powers of the past (USD led) tightening in financial conditions; and the signal from a flatter yield curve...
Table 1 shows how FX and bond markets have typically registered much larger (absolute) one day price changes on days when FOMC’s end with a press conference than when they don’t. These FOMC press conference daily moves also vastly exceed the sustained reaction on payroll days. The reasons are not hard to find – FOMC days with press conferences, have the Fed Chair Q&A, as well as the economic projections and the notorious dot plot to respond to.
On these main elements, we expect the March meeting to break as follows:
i) The dot plot. DB’s econ team expects the median dots to come down by 25bps for all of 2016, 2017, 2018 and the longer-run. Prima facie this may seem dovish but the dots will have to come down by more than this, especially the 2016 dot, to be seen as genuinely bullish, because the market is pricing in so much less than the Fed projects. The market has less tightening priced in for the end of 2018 than the Dec FOMC median dot for the end of 2016!
ii) The balance of risks. This is where the recovery in domestic and international risk appetite kicks in. Expect this to shift to “risks are nearly balanced”. This is a minimum condition needed to signal that all FOMC meetings (including the April meeting) are ‘live’.
iii) The forecasts: Expect minor adjustments. 2016 median inflation forecasts will likely be revised up 0.1% to reflect recent stronger PCE inflation; and, median growth forecasts revised down 0.2% to 2.2% because of weak international growth. The tone on inflation should be less concerned about a target undershoot, compared to the prior statement that mentioned a ‘current shortfall in inflation’.
iv) The tone of the press conference. Here Janet Yellen will try keep her options open. This also means leaving the door wide open to a June hike, and even ajar to an April hike, on the big provisos that March NFP is strong enough, and global risk appetite holds up. The market will see this as more hawkish than currently discounted.
The above signals should affirm that the Fed remains considerably more hawkish on both the short and longer-term trajectory for fed funds relative to the market. At the margin this is USD positive, even if the market has treated the Fed’s views with some skepticism for many years. This is different from 2015 when the USD ended weaker versus the EUR after every FOMC meeting where there was a press conference
The Fed of course tries to stress data dependence, but there are two big sources of uncertainty that are interesting now that are adding further to data dependence and where the Q&A could be informative.
i) There are questions on the reliability of financial conditions tightening and its impact on growth and employment.
Financial conditions have tightened and yet services employment has ploughed ahead. If employment keeps on growing at this pace in coming months it will be suggestive of a service economy that is unresponsive to the key FCI elements encouraging a slowdown, notably the strong USD.
ii) The yield curve and growth. If the Fed believes that the flat yield curve is being driven by international events (global disinflation; and, ECB and BOJ easing offsetting negative EM reserve growth) then there are less growth concerns related to a flattening yield curve and the Fed can more readily tighten. In the most sanguine scenario, a well behaved back-end of the curve (and yield curve flattening) would allow the Fed to tighten more rather than less, as should have occurred in the last two Fed tightening cycles. If however, the recent flatter curve is more a function of restrained growth expectations - the traditional yield curve signal - then the Fed should be more wary of adding to this flattening by tightening more.
As per Figure 2, the yield curve leads 6m average change in NFP by a lengthy 27 months. By that token, the yield curve flattening is less worrying in so much as it portends a NFP slowdown far ahead in 2017/8. However, it also suggests that employment has not dodged all future concerns related to a flatter curve. The biggest worry is that the economy is fully priced to a 2% 10yr yield, and cannot sustain long-term rates much above that, suggesting the longer-run equilibrium funds rate is far below the Fed’s estimates.
In general, the issues of financial conditions and the yield curve leading employment growth are major sources of Fed uncertainty that favor policymakers taking a cautious line in responding to the recent ongoing strength in employment growth and better risk appetite.
Right now that is an argument for waiting out the April meeting and thinking about June as the most likely next Fed tightening.
While we expect the immediate market reception to the FOMC meeting will be USD positive, the follow through reaction will be very restrained. For one thing, USD bulls have been recently burned. Until the market can see the whites of the eyes of the Fed - which means the market gaining confidence that the Fed will pull the trigger at the next FOMC, whenever that is – USD gains in response to more ‘hawkish’ Fed news will be constrained, and the market’s attention will quickly shift elsewhere. Fed tightening, and US policy rates climbing the G10 ranking table is still key to the long-term USD cycle support, but we are not in the thick of this policy story, yet.
So, as Citi's Donnelly concludes, the big question is whether the FOMC has enough confidence in the global situation to describe risks as balanced or (more likely) “nearly balanced”. Balanced or nearly balanced is somewhat hawkish as there is no question about the domestic triple mandate (inflation rising towards target, UR < NAIRU, stocks near the all-time highs) and thus balanced risks should open the door for April (unlikely) or June (likely). The only reason the Fed is not hiking today is because it’s not priced in. When they say data dependent, they mean they are watching the following data (and some other stuff):
- Inflation
- Jobs
- Global economy
- SPX
- WIRP
- USD
I would say 5 of 6 allow for a hike today but #5 (what’s priced in) is not high enough to allow the Fed to pull the trigger. WIRP over 60% is required for a hike. To get June pricing up, a balanced statement full of optionality is the best strategy. So my base case is a hawkish, balanced statement that leaves April open and strongly suggests a June hike. If that is what we get, expect similar price action to October 2015, which looked like this:
And then finally, there is the bankers - who are demanding rate-hikes...
America’s biggest banking association has urged the Federal Reserve to hold firm with its plan to tighten monetary policy, arguing that protracted delays in rate rises — or, worse, going negative — could have damaging consequences.
On the eve of the central bank’s next meeting on rates, James Chessen, chief economist of the American Bankers Association, warned that loose policies were building up problems in the economy.
Because this won't end well...