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Key times – The FOMC statement (also containing the Summary of Economic Projections) is released on 15 June at 04:00 AEST. Federal Reserve Chair Janet Yellen then delivers her press conference and question and answer session at 04:30 AEST.
Key markets to watch: USD (notably USD/JPY), Wall Street cash, US volatility, 5-year T-Note Decimalised, gold, US financials, EEM ETF (emerging market ETF).
Understanding the meeting:
There is little doubt that the 15 June FOMC statement (released at 04:00 AEST) and Janet Yellen’s subsequent press conference (04:30 AEST) is about looking forward and understanding market pricing of rate hikes at future meeting, rather than whether the Federal Reserve (Fed) raise rates at this meeting.
One clear smoking gun, if we look back to the minutes from the May FOMC meeting, is the line that “most participants judged that if economic information came in about in-line with their expectations, it would soon be appropriate to take another step in removing some policy accommodation.” The key word being ‘soon’, and with traders having priced in a 90%+ chance of a hike into the fed fund futures (a tradable interest rate market) for some time, the various Fed members have had every chance to push back on these high expectations. Remember, there is a reason why there is such low implied volatility in financial markets and one of these reasons is very predictable monetary policy settings from key central banks. The Fed don’t like to surprise.
Given the fact the market has priced in such certainty, if the Fed don’t hike the funds rate then the USD will take a bath, although one would expect them to give a clear signal that they will hike in the July meeting and this could limit the selling in the USD. Perhaps the bigger issue for markets is three-fold.
Three key consideration:
Soft economic data
Firstly, there is little doubt that US economy has been going through a soft patch in the economic data flow (we can see that in the Citigroup economic surprise index below), or what the Fed has classified as a “transitory” period. After such a weak Q1, with GDP printing a meagre 1.2%, the consensus (from economists) is we see a better Q2 with growth likely to come in at 2.4%, with the estimates ranging from 3.1% to 1.8%. However, if we look at the bond market and the strong flattening of the US fixed income yield curve, we can longer-term growth and inflation expectations falling fairly rapidly. So, with the Fed having a chance to assess and aggregate all the recent data points it will provide a chance for traders to see the Fed mark-to-market the soft data flow relative to their own forecasts. Recall the Fed see the “near-term” risks to their outlook as “roughly balanced” and that shouldn’t change.
A strange dynamic to focus on
I think it’s important to point out that the Fed will be concerned about raising rates when five-year inflation expectations have dropped 20 basis points (bp) since the start of May and at 1.91% sit at the lowest levels since 8 November. We have also seen the US yield curve (or the yield difference between 10-year and two-year US Treasuries) fall close to 50bp since the start of the year. However, at the same time overall financial conditions remain ever more accommodative and the gains seen in the S&P 500, coming at a time of tighter credit spreads, falling ‘real’ (or inflation adjusted) bond yields and extremely low implied market volatility have actually had the same economic effect since March as a 25bp CUT to the fed funds rate.
Secondly, traders will assess if we see changes to the central banks economic projections.
Specifically, we want to see if its current estimates of GDP to average 2.1% in 2017, 2.1% in 2018, and 1.9% with the longer-run estimate at 1.8% change. Its view on core inflation (PCE) will also garner focus and whether they leave its projections of 1.9%, 2% and 2% (for 2017, 2018 and 2019) unchanged from its March statement will be of interest. It would not be a surprise at all if the bank lowers its 2017 core inflation forecast from 1.9% to say 1.7% the recent soggy reading in US inflationary readings.
Will the ‘dots plot’ be moved higher?
The other aspect is the so-called ‘dots plot’ projection, which is effectively the Fed’s median projection for where the fed funds rate should be in the years ahead. This is important as it puts into perspective the translation from each Fed members growth, inflation and unemployment estimates into where the fed funds rate will be at different intervals going forward. The interesting dynamic here is the market is not on the same page and is wholly pessimistic about future hikes from the Fed.
We can look at market pricing and see 36bp of hikes priced in for this year, so effectively a hike in June and a 44% chance of another by year-end. The Fed have two pencilled in. We can see that through to the end of 2019 the market is pricing in 80 bp of hikes (or around three in total), relative to the Fed who in March detailed a median projection for the fed funds rate at 300bp (or 3%) and therefore calling for over eight hikes.
Keep in mind that while we may see the median expectation for the 2018 fed funds rate to be lifted from 2.1% to say 2.3%, it will be driven by structural reasons, with Daniel Tarullo leaving the board, so without his input, it should automatically push up the central projection. Therefore, don’t read this change as a hawkish development and to subsequently buy USDs.
It’s this divergence in market pricing that is creating good trading opportunities. There could be serious upside to the USD (specifically against the JPY and AUD) and downside to US Treasuries if the Fed path of hikes proves to be true. That’s a huge ‘if’ though and the market is clearly pessimistic about this playing out and to be fair it is not going to be clear in the short term.
Eyeing the balance sheet
Thirdly, any further clarity on the Fed’s $4.46 billion balance sheet will be closely followed. Recall these are US Treasuries and Mortgage-Backed Securities (MBS) the central bank have been accruing as part of their various Quantitative Easing (QE) programs. Allowing a number of maturing bonds to run-off and therefore not reinvesting these proceeds into new bonds will act as a tightening of monetary policy, akin to raising the fed funds rate. The market is clearly saying that ‘normalising’ the balance sheet removes the need to raise rates to the extent the Fed had projected. Traders want to understand the dynamics of a reduced balance sheet and increasing interest rates concurrently.
What’s the trade?
The USD will take its cues from the US five-year Treasury, and perhaps the yield curve more broadly, so any selling here in the wake of the statement should push up the USD. Specifically, I would expect USD/JPY to be the most sensitive to this meeting and I would not be surprised to see signs of traders who have been short USD/JPY covering position as we head into the meeting, which of course should push USD/JPY into ¥110.50. It’s hard to see the Fed being overly hawkish, but naturally, it’s all about what we see and hear relative to expectations and market expectations currently are very subdued.