Here’s How To Trade Today’s Fed Decision And Powell Presser
While some, like DB’s Jim Reid, say today will be the most important FOMC meeting of Jay Powell’s career, others are more cynical and correctly conclude that even if the Fed chair wanted to take steps to preempt red-hot inflation, his arms are tied.
“The FOMC meeting is unlikely to offer any surprises today as the Fed has painted itself into a corner,” said a rather cynical Kaia Parv, head of research at FXPRIMUS. The Fed is clearly hesitant to disturb the markets since an increasing portion of U.S. household wealth is tied to equity investments.”
Ok, fine the Fed won’t dare to rock the boat, so what can the Fed do as it seeks to answer the three key market questions: i) does taper talk begin; ii) are recent inflation pressures enough to raise the median dot to show a hike in 2023?, iii) how will the FOMC revise its statement to address the fact that inflation is no longer running below 2%?
Let’s start with the…
As we discussed at length last night, we will get a dots update from the Fed…
… where a majority of economists expect at least one hike in 2023. For that to happen, three policy makers adjust their dots higher.
Goldman also does not see the all important median 2023 dot rising, even if it expects the average 2023 dot to increase… but not enough to telegraph consensus on a 2023 rate hike.
As Std Chartered’s Steven Englander said last night, “it is a close call on a 2023 hike in the June projections; on balance we think the FOMC will wait until 2024 projections are introduced in September and put the first hikes in 2024.” As Englander also predicts, “the ongoing absence of 2023 hike in dots may be read as dovish.” And in a market where everyone is hawkish – at least when it comes to Treasurys judging by the record net short as per the latest JPM Treasury Client Survey…
… we could see a massive short squeeze as the most solid bear case for rates – if only until the next FOMC meeting – collapses.
There is a (very) tiny chance Powell will emphasize tapering (more than just talking about talking), even though consensus expects the discussion on scaling back monetary stimulus not to begin in earnest until August’s Jackson Hole at the earliest (if not later).
Goldman – which arguably sets Fed policy – is clear: “it’s too soon to “start the taper clock“…
… adding that that “we do not expect Chair Powell to deliver the first hint at tapering in June.Participants have begun “talking about talking about tapering,” and some would like to get the process underway sooner in case inflation pressures prove persistent. But we think that Powell likely agrees with Governor Brainard and President Williams that the labor market has not yet come far enough. We continue to expect the first hint in August or September, followed by a formal announcement in December and the start of tapering at the beginning of next year.”
In the end, it is difficult to see how the Fed could surprise markets much with this FOMC decision. Attention and a certain level of trepidation should shift to the Jackson Hole Meeting in August. That is where it will become interesting again. Englander agrees that there is a small chance the FOMC could indicate it is advancing its normalization schedule, but at current yields such a shift would likely have a big bond market impact – the 10Y yield today is below where it was at the April and March FOMC meetings…
… and Powell surely recognizes the potential embarrassment of another episode of premature hawkishness (recall Q4 2018). Instead, the FOMC comments will be in the context of sluggish economic data (including a risk of soft May retail sales data, due 15 June) and much less aggressive market pricing. The FOMC is also much more likely to advocate and practise patience in assessing the underlying trends in activity and inflation, which points to very moderate signals. Yields have some downside if the FOMC sees the recovery as being more sluggish than earlier expected, but such overt pessimism would surprise us.
The FOMC may raise its growth forecast for 2021 to 6.6% and its inflation outlook to 2.7%, while looking for an unemployment rate of 4.7%. Ironically, according to Standard Chartered, the biggest risk of a yield spike can be found in the projections, because while the bank does not see a spike in yields, this could take place if the tapering discussion is accompanied by added inflation concerns in the out years.
Many have discussed labor-market tightness, but real wages have not moved much this year, with inflation offsetting a big chunk of nominal gains. And inflation expectations in surveys such as the New York Fed’s still show increases in the coming years. So far the upward inflation move is heavily concentrated in a few small sectors. The bank expects the FOMC to argue – what else – that the evidence supports a transient rather than permanent inflation pick-up, but perhaps with slightly less conviction than before.
Given the decline in breakevens recently, particularly in the 2Y-3Y sector of the curve, Englander cautions that the market may be caught off-guard if the 2023 core PCE projection rises from March’s 2.1% forecast. Markets could see such a rise as inconsistent with the Fed’s view that the inflation pick-up is transient. A 2.2% core inflation projection for 2023 could be seen as close enough to the upper end of “somewhat higher” to justify beginning policy rate normalization. We think that nine (including Powell) will push for unchanged signals, and expect a few swing participants to go with the Chair. While projections are not discussed or debated at FOMC meetings, participants do develop an understanding of which projections are potentially sensitive and reflect carefully on those projections.
Finally, some thoughts from Jon Turek: “The way the Fed adds legitimacy to the 2023 fed funds dot, which has de facto became the markets litmus test for FAIT (average inflation targeting), is to be revising up growth and inflation without changing the timing for rate hikes. They passed in March, and I think they’ll pass again in June. The only thing to watch for is the 2022/23 PCE dot, if those were to rise, then I think the Fed can sell a rise in the ’23 fed funds dot in a dovish fashion.”
Here, too, we could get a hawkish and dovish surprise. Yields could also rise if Powell looks through recent data, conveying a message that the Fed is convinced that the current soft data patch is temporary. But given FOMC emphasis on making policy based on current data, he is likely to argue that they expect robust growth but need to see how growth plays out.
On the other hand, the biggest dovish risk that we see is if the unemployment rate projections rise. The unemployment trend since January does not jive with the current 4.5% median projection (Figure 2). If that rises, and especially if the increase is not made up in later years, investors may contemplate an even slower anticipated future tapering path. Powell has been at pains to stress that projections are not policy signals, but more elevated unemployment projections would be indicative of added caution on growth prospects. While Fed rate hike pricing has retreated somewhat since the March and April FOMC meetings, the market still prices in about 2½ hikes by end-2023, so there is room for further paring if the projections suggest slower normalization (Figure 3).
Expect the press to press Powell on tapering, and since there are enough FOMC participants arguing that is time to begin the tapering discussion, it would be a surprise if there were none. Too many Fed speakers have mentioned tapering for it not to be discussed; it would look as if they were avoiding mention of the elephant in the room.
However, the possibility of near-term tapering will be dismissed quickly without mention in the statement. Given the run of data, it is more credible for Fed Chair Powell to say that there was broad agreement that sufficient progress had not yet been made and concrete discussion was premature.
Englander thinks that the bond market will initially react negatively to the mention of a tapering discussion. The dominant market view looks to be that any mention of a tapering discussion is the first step towards normalization. But such a reaction is unlikely to persist and expect the dismissal of an imminent move to reassure investors. The scenario would be different if payroll gains had averaged 900,000 the past two months rather than 418,000.
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Going back to our point that the odds today are greater for a dovish surprise, Avalon notes that little of the above above would be a shock to markets: Rate hikes are already expected to occur in 2023 with a bit risk one will happen in 2022. This is inline with the Fed’s thinking. Current inflation is not going to push the Fed into doing anything rash, and employment is lagging. The market already knows that pushes hikes out into 2023. In a recent survey of economists, Bloomberg found that expectations are centered around the fourth quarter of 2021 and the first quarter of 2022 for the asset taper to begin. The same survey found that the Fed is likely to signal its intention to taper at the Jackson Hole Symposium in August. This makes sense given it is a high profile event where previous announcements have been made.
As Avalon concludes, “there is not much to shock the market on the hawkish, tightening policy side. If there is significant pushback from Fed officials about the prospects of an imminent taper, it would be incrementally dovish and further diminish the chances of a hike in 2022.“
With plenty of ammo to shoot down any inflation fears (for the time being), the concentration will be on how the Fed judges the progress and the future development of the labor markets. Is the Fed waiting for progress on participation? That would be a longer time horizon than a declining unemployment rate. The language used around the employment side of the Fed’s mandate will be the most meaningful. But it is already a known that substantial further progress has yet to be made (and it will take time).
In the end, it is difficult to see how the Fed could surprise markets much with this FOMC decision. Attention and a certain level of trepidation should shift to the Jackson Hole Meeting in August. That is where it will become interesting again.
One final point: The FOMC statement currently motivates the average inflation targeting (AIT) plan — the intention to “aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time” — by noting that inflation is running persistently below 2%. This is no longer true, and how the FOMC addresses this is a wild card for the June meeting.
In other words, the inflation update in the statement could edit the May comment to implicitly acknowledge higher inflation but not as a policy factor: “With inflation running persistently below this longer-run goal, The Committee will aim to achieve inflation moderately above 2 percent for some time”.
Here Goldman believes that while a small fix might work for now, at some point the FOMC will need to explain what, if anything, AIT still demands if inflation runs far enough above 2% this year to have averaged 2% or more by the time tapering is complete and rate hikes are on the table.
We suspect FOMC participants have different views on this question. The language in the FOMC statement, which mirrors the language in the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy, is backward-looking in nature. A hawk might therefore say that once the average is back to 2%, there is no further need to aim above 2%, and if this is achieved before liftoff, then the liftoff criteria should drop the current requirement that inflation “is on track to moderately exceed 2 percent for sometime.” A dove might instead interpret AIT as less about making up the exact shortfall in the current cycle than about aiming moderately above 2% in expansions in general in order to balance being below 2% during recessions.
Goldman concludes that this is a big question, and it is unlikely to be settled definitively on Wednesday.
Wed, 06/16/2021 – 12:56