Monetary Policy & Inflation | Rates | US
[Market implication: US curve steepens]
Cracks are forming on the fringes of credit markets, but most asset classes are doing well year-to-date and have avoided any major corrections. Even the likes of BBB credit have managed to fully reverse the widening move of 2018Q4. Meanwhile, stocks, which many portray as hanging on by a thread, are near record levels. Equally interesting is that equity indices have entered into each Fed meeting this year near their highs…
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[Market Implication: US Curve Steepens]
Cracks are forming on the fringes of credit markets, but most asset classes are doing well year-to-date and have avoided any major corrections. Even the likes of BBB credit have managed to fully reverse the widening move of 2018Q4. Meanwhile, stocks, which many portray as hanging on by a thread, are near record levels. Equally interesting is that equity indices have entered into each Fed meeting this year near their highs.
The same is basically true for 10-year US yields. Even during the meetings where they delivered rate cuts, we saw conciliatory rises in yields ahead of the FOMC meeting (just in case it was a ‘hawkish cut’). After the meeting, yields would typically fall by a small amount. However, since the last rate cut the back end of the curve has been doing most of the work, albeit sitting in a range.
That is not to say that we have lacked fireworks this past year. As we wrote extensively elsewhere, repo market gyrations since mid-September have many concerned that something more nefarious is at play.
As we head into the last Fed presser meeting of the year, it will come down to the Fed’s actions over their words.
Scenarios: No cut, on year-end alert, inflation overshoot talk a risk
• Base-case: With the trade deal uncertainty still hanging over the economy and markets, the Fed will maintain a cautious tone but likely refrain from delivering new easing measures (either rate cuts or a new facility, like the SRF or more QE). Data has been mixed but last week’s solid employment report gives the Fed some cloud cover to take a wait-and-see approach into 2020.
The FOMC will likely reiterate that policy remains appropriate and that rates will remain on hold for 2020. At this meeting the press conference matters more than the statement and Summary of Economic Projections (SEP) forecasts. We expect Chair Powell to downplay concerns over the repo operations. He will likely state that reserves in the system are slowly returning, but that the Fed remains on alert around year-end.
• Hawkish-case: It’s a low probability outcome, but we are re-introducing the hawkish case in this preview in the event the Fed is increasingly more confident that it has managed to ‘soft land’ the economy. Although we do not think SEP projections (i.e. the dots, Chart 1) have the same sort of cache as before, the risk is that their path will maintain the upward bias for 2021 and 2022.
Chart 1: Fed and Market Projections for Policy Rates
Source: Bloomberg and Macro Hive
• Dovish-case: Building upon the base case scenario, which is already leaning to the dovish side, the Fed could deliver a dovish message in a couple ways. The most straightforward way would be to flatten the dot plot and suggest hikes are no longer on the cards as far as the eye can see. In many ways, recent Fed speeches suggest that they would only raise rates if inflation is consistently running above their 2% target. Related to this would be if Chair Powell mentions that the Fed is close to making a change on their 2% target and would be introducing a new framework that would allow for periods of inflation overshooting ahead.
On the more technical front it’s been discussed at various FOMC meetings and highly debated in the marketplace that if the Fed are close to being ready to launch a standing repo facility, now would be the best time for shock and awe value ahead of potential year-end funding pressures. In addition, the Fed could remind market participants that the FX swap lines are always available if there were to be any dollar shortages as well into year-end.
Market Implications: At the end of the day, the Fed is reluctant to tighten financial conditions into year-end, especially with the trade deal uncertainty still lingering. The best path for the Fed is to sound dovish, given the sort of year we have had (and with year-end so close), and save any hawkish views for 2020. That should help the curve keep its steepness.
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
No earthquake no rate hike?