FOMC Preview: Meeting Likely to Steepen Yield Curve

Summary

• The Fed has already pre-announced QE start and a 50bp hikes.
• The real uncertainty is whether Powell hints at a much higher terminal and neutral FFRs than in the March SEP.
• This seems unlikely, which could further lower market confidence in the Fed’s inflation-fighting mojo and further steepen the yield curve.

Market Implications

• Curve steepening.

Pre-Meeting Fed Hints Imply QT Start and 50bp Hike 

As usual, the Fed hinted at its policy changes ahead of the meeting. Based on the March minutes, QT is likely to start:

• Monthly reinvestment caps would be $60bn for Treasuries, $35bn for mortgage-backed securities (MBS).
• The cap would be phased in over three months ‘or modestly longer if market conditions warrant.’
• When Treasuries principal repayments fall below the $60bn cap, the difference with the cap is to be made up by not reinvesting TBills.
• Because MBS redemptions are likely to remain well below the cap, and because in the long term the Fed wants to hold only Treasury securities, the Fed intends to proceed with outright sales of MBS ‘after balance sheet runoff is well under way’.

The meeting is likely to specify the details, including of the phase-in period, which could be, e.g., $30bn in May, $60bn in June and $95bn thereafter.

In addition, before the pre-meeting blackout, Chair Jerome Powell expressed support for a 50bp hike next week, as currently priced in. I find the risk of 25 or 75bp low:

• With inflation at 8.5%, if the Fed delivers less than the market expects, it will further lose credibility. Also, while financial conditions have tightened, the Fed finds the labour market very tight and expects GDP growth above potential this year: with high inflation, the Fed put is effectively gone.
• Meanwhile, FOMC members have been pushing back against 75bp, possibly because their current understanding of inflation implies that it is not necessary.

Terminal Rate Likely Unchanged, But FFR Hikes Brought Forward

The more interesting info to be gleaned from the meeting is whether the Fed has changed its estimates of the neutral rate, 2.4%, and the terminal rate, 2.8%. Pre-meeting FOMC chatter implied that the FFR would be brought to neutral by end-2022. The Fed has effectively revised up its end-2022 target to 2.4% from 1.9% at the March meeting and 0.9% at the December meeting.

Following the publication on Friday of an Economist editorial highly critical of the Fed – and predicting a 5-6% terminal FFR – Powell is likely to face strong pushback during the presser.

I expect Powell to respond with his usual ‘we will adjust policy as needed in order to ensure a return to price stability with a strong job market’ rather than signal a large change in either neutral or terminal rate. This is because the current estimates reflect the Fed’s strong beliefs in its inflation models, namely the expectation-augmented Phillips curve and a low neutral rate (Terminal Fed Funds to Approach 8%).

The Fed inflation model implies that, as long as inflation expectations are anchored, inflation should be self-correcting. The data has falsified this: inflation has been surging against stable inflation expectations (Chart 1). Nevertheless, stronger evidence will likely be needed for the Fed to raise its expectations of the terminal rate close to my 8% forecast, for instance the FFR above 3% and core inflation stable above 4%. These may not become available until end-2022.

Instead, I expect the Fed to follow the market that is currently pricing 50bp hikes in May, June and July. As inflation remains high, I expect the market to gradually price 50bp hikes at the remaining policy meetings and the Fed to follow the market.

Market Consequences

The yield curve has recently steepened. I think that reflects a loss of confidence in the Fed’s ability to control inflation based on its current policy framework (Chart 2). The loss of market confidence is shown by 5y5y BEs breaking the 1.5-2.3% range of the past five years even though expectations of the long-term policy rate, e.g., the 2y1m OIS forward swap, have increased to post-GFC highs (Chart 3). Basically, the market is less and less convinced that a terminal rate of 2.8% can slow inflation currently at close to 8.5%.

The Fed sticking to its current policy plans at next week’s meeting is likely to deepen the market’s loss of confidence and therefore see the curve steepen further.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(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.)