FOMC Preview: Cautious Yellen likely aiming to limit market impact of rate hike, but watch term premia

This post summarises my views on Wednesday’s much-anticipated US Federal Reserve meeting and potential 2017 trends.  The main points are:

  • A 25bp Fed rate rate hike is fully priced by Fed Funds futures – given the improved US macro situation, Trump’s prospective (but uncertain) fiscal stimulus and strong signals from Fed Governors. So the market focus will be very much on extracting signals the future pace of US rate hikes.
  • My central case if for Yellen to be measured and neutral sticking to the existing script about only gradual future rate hikes and no pre-set course.  The Fed will likely want to avoid giving extra impetus to the recent Trump-driven tightening of US financial conditions (see chart) since that would hit the economy way before the boost from any fiscal expansion. The Fed should have learnt lessons from the overly-confident December 2015 rate hike (see here).
  • While Yellen will likely acknowledge that the Fed is close to achieving its objectives, she’ll probably also note continuing economic challenges (subdued US fixed investment, weak productivity growth) and could follow Governor Dudley in arguing that it’s too early to form a definitive view about Trump’s fiscal plans i.e. signalling a Fed is in wait and see mode.
  • So Fed’s economic projections and ‘dot plot’ could be little changed, continuing to signal two rate hikes in 2017. And that would likely lead to limited market impacts – if anything positioning unwinds could lead to limited Treasury yield and dollar retracements. Markets now seem to be awaiting firmer evidence on the Trump fiscal stimulus.
  • But the risks are skewed to the Fed being interpreted as slightly hawkish, which would likely see the recent Treasury selloff and dollar strength extend. And there would likely be greater spillovers onto (exposed) european yields.
  • Further rises in treasury yields and dollar strength seem likely in 2017.  While my central case is for gradual grinds upwards, market participants could again start romancing the idea of an early-1980’s style rise in Treasury yields and the dollar rally on signs of a bigger Trump fiscal stimulus than already priced.
  • While I argued here that the chances of €/$ parity are the best for several years (helped by potential US foreign earnings repatriations, see Trump win underpriced) dollar upside could be constrained by the need for further US economic progress, the Fed remaining cautious Fed, dollar valuation concerns (given subdued surveys of export orders) and political-economy factors. Dollar risk reversals are consistent with that.
  • But Treasury term premium have significant potential to rise back to more normal levels (see Chart). And, depending on global growth, such rises could be exacerbated by market risk appetite being hit by risk factors such as Trump’s protectionist potential.

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US Macro Situation has improved and Fed Governors signalling rate hike: market watching for future signals on Wednesday

The big picture is that the macro case for a 25bp US rate hike has been steadily building, and has been reinforced by Trump’s election victory. Specifically:

  • US growth hit a two-year high in Q3 (see Chart), driven by consumption as unemployment fell to only 4.6% (close to the Fed’s natural rate estimate) and wage growth has firmed (although it retraced a little to 2.5% in November).
  • The ISM non-manufacturing survey rose to its highest since October 2015, with manufacturing survey also showing more signs of life (see Chart).

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  • Core PCE deflator inflation has risen this year (see Chart) and is anticipated to rise towards the Fed’s goal next year as spare capacity is used up as growth continues.
  • Market inflation compensation measures (breakevens) have spiked notably as part of the Trumpflation trade, departing significantly from their previous close link with oil prices (see Chart).  University of Michigan consumer inflation expectations have also stabilised, although the Fed would probably like to see them rise.

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Alongside this, a range of Fed Governors have strongly signalled that a 25bp rate hike is appropriate on Wednesday.  Importantly, this includes more dovish governors such as Bullard (although he’ll probably stick with his ‘one and done’ view).  So this looks to be a Fed reaching consensus in December.  Hence Fed Funds Futures have fully priced a 25bp rate hike – and the focus on Wednesday will be about divining signals about the future pace of rate hikes.

But macro still reasons for Fed caution, probably too soon to build in full Trump fiscal boost

It’s important to appreciate, however, that despite the steady improvement the US economy is by no means yet booming – the expansion is only at a ‘moderate rate’.  Indeed several factors support likely continued Fed caution.

  • The recovery still appears overly dependent on consumption – fixed asset investment has been notably subdued (see Chart) and productivity has been exceptionally weak.
  • The Q3 GDP boost from net exports could prove a false dawn – it was helped by weak imports (of capital goods) and erratically strong soybean exports.
  • US exports face the headwind of the stronger dollar (I show below that the real $TWI has already risen above long-term averages) with survey export orders already looking a bit sketchy (see Chart).

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The elephant in the room is obviously the size/timing of the prospective Trump fiscal stimulus.  But given the considerable uncertainty (precise measures eventually proposed and whether they can clear Congress) YelIen and other FOMC participants could well follow Governor Dudley  by concluding that it’s too early to form a definitive judgement about president-elect Trump’s fiscal plans i.e. signalling a Fed in ‘wait and see’ mode.

Fed also won’t want to stoke further tightening of financial conditions: dot plot probably little changed and stick to ‘gradual increases’ script

And the issue for the Fed is that the market anticipation of such stimulus (the ‘Trumpflation’ trade) has already caused a tightening of US financial conditions (see chart, higher Treasury yields and dollar appreciation have been offset by buoyant equities) which will hit the US economy way before the boost from any fiscal expansion.  So the Fed likely won’t want to add to that tighter financial conditions dynamic.  And the Fed should internalise the lessons from the overly-confident December 2015 rate hike (see here), when Treasury yields and the dollar initially rose (although they subsequently reversed quickly as China concerns hit in January).

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So I’m expecting Yellen and the Fed to be measured and neutral on Wednesday:

  • Sticking to the existing script that future rate hikes will be gradual and depend on continued macro progress, rather than being on a pre-set course
  • The eventual end-point considerably lower than in previous rate hike cycles – the decline in the ‘neutral’ policy rate, driven factor such as weak productivity and demographics, means that Fed policy is less loose than the raw rate implies.
  • Leaving the summary of economic projections (SEP) and Fed dot plot relatively unchanged (i.e. not yet incorporating a large fiscal stimulus), with the stability of the dot plot following a sequence of downward revisions as the Fed increasingly adjusted in line with market pricing. Specifically, the dot plot will likely again signal two 2017 Fed rate hikes, followed by three hikes in both 2018 and 2019.

Probably limited initial market impacts, but some risk of hawkish interpretation

And given that the market is also currently pricing two 2017 rate hikes, the market reactions will likely be muted (markets will likely downplay the 2018 and 2019 dots continuing to exceed market expectations).  That said, there could obviously be some high-frequency volatility as the messages are digested.  And positioning and technical factors will likely be important.  But if anything Teasury yield and dollar could retrace a little if Yellen successfully convinces markets that the Fed remains in wait and see mode.

That said, several factors suggest that the risks are skewed to the Fed being interpreted as slightly hawkish, although none is definitive.

  • Some FOMC members could conceivably revise up their dot plot submissions if they anticipate some Trump fiscal stimulus and/or worry more about future financial stability risks.
  • Yellen could sound relaxed about the rise in Treasury yields and the dollar. Their impact on US financial conditions has been offset by equity price rises, so the overall tightening has been smaller than in early 2016.  And the tightening arguably reflects ‘good’news about US growth prospects. Moreover, the recent Tresury yield rise reflects term premia starting to adjust to more normal levels (see chart), which can be viewed as a positive development.
  • FOMC members may worry less about global economic prospects and hence the overseas impact of their policies, plus eventual feedbacks onto the US.  For example, the JP Morgan Global PMI rose to an 11-month high in November (see Chart). That said, emerging markets have unsurprisingly fared worse than developed markets after Trump’s victory (see my Trump win underpriced piece), both because of the resulting US Treasury selloff and protectionism concerns.

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Such a mildly hawkish Fed scenario would be more likely generate a fresh Treasuries sell off and limited dollar strengthen.  But the sustained sharp market moves following Trump’s win are unlikely to be repeated.  Traders are now looking for firmer evidence that a substantial fiscal stimulus actually gets proposed and overcomes potential Congressional resistance.  And quite a lot of fiscal stimulus is already priced.

European fixed income markets would, however, be more likely to sell off a little in sympathy in this more hawkish Fed scenario. BTPs and OATs have been vulnerable to political risks while SGBs have been steadier (see chart and here).  Last week’s ECB QE extension, and promise of QE flexibility if required, could well provoide a near-term confort blanket. But the Euro remains vulnerable to the prospective Fed-ECB divergence and on-going political nerves.

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Further gradual rise US yields and dollar in 2017: treasury term premia could continue but dollar valuation concerns could rise

The big picture for 2017 is likely to feature further rises in Treaury yields and dollar appreciation, although the extents are uncertain.

Such further rise will require the Fed to be confident that the gradual US recovery is extending and  broadening i.e. moving beyond ‘moderate expansion’.  And that in turn will require hitherto underperforming economic components to pick up the slack.  That will principally be about fixed investment and productivity improving.  But it would be helped by the stronger dollar not dragging excessively on US exports and manufacturing.

But the main uncertainty obviously relates to the size, composition and timing of the eventual Trump fiscal proposals, plus their chances of gaining congressional approval and the news relative to current market expectations. Notably, Fed governors Dudley and Bullard have recently cautioned that crisis-type US fiscal stimulus isn’t appropriate (they prefer infrastructure investment and better fiscal automatic stabilisers). So should Trump show signs of throwing caution to the wind markets participants could again start romancing the idea of an early-1980’s style rise in Treasury yields and the dollar rally in such a loose fiscal-tigher monetary policy mix.

While obviously a risk, my base case is that Trump will end up being pragmatic and/or private sector funding of infrastructure spending falls short of his aspirations.  So my base case is for 2017 to feature a gradual grind up of Treasury yields and the dollar. While the Fed dot plot will gradually incorporate reactions to the prospective fiscal stimulus, I anticipate the Fed remaining cautious until at least mid-year. And quite a lot of fiscal stimulus already appears priced (although it’s difficult to calibrate this), thereby potentially causing periodic positioning adjustment until there’s full visibility on the fiscal expansion.

Rises in Treasury yields seem likely to continue to be supported by term premium rising back towards more ‘normal’ levels. Even though higher term premia account for most of the Treasury selloff (see above) the big picture is that term premia remain very low in a longer-term context (see chart). Specifically, the 10 year Treasury term premium is now only marginally positive and remains 1.5pp below it post-1962 average (1.0pp below post-1995 average). And mean reversion tendencies, with the normalisation of the US economy, could potentially see the 70bp rise in Treasury yields since Trump’s win matched or exceeded over the coming months.

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And this is a dynamic which the Fed could end up having difficulty controlling.  Although it’s a positive sign of economic normalisation, this dynamic could be amplified if buoyant market risk appetite starts being challenged by risk factors such as potential Trump protectionism, European politics, the start of Brexit negotiations and Chinese debt concerns. That said, markets could well maintain their recent glass half full view of such risks if global growth continues improving. But those risks are likely (hopefully!) smaller than those during the global financial crisis, when the Treasury term premium was around 3pp higher than recent levels.

The prospective dollar appreciation could, however, be constrained by growing valuation concerns – especially given Trump’s election promise to ‘make America great again’.  Specifically, while the recent dollar appreciation has only taken the nominal TWI to around it’s long-term averages (see chart) the real TWI is actually already (data second chart, monthly data only to October).

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Obviously it’s in the nature of exchange rates to periodically over/undershoot their medium term equilibria, especially if foreign economies are suffering and/or foreign central banks are easing (last week’s ECB extension). But, as detailed above, US export order surveys already look sketchy.  And US manufacturing and exports suffering from dollar strength sits uneasily with Trump’s election promises. Plus dollar strength raises the chances of Trump labelling China a currency manipulator (despite China’s significant loss of FX reserves controlling the depreciation) and imposing large tariffs on China risks provoking a very damaging trade war which would likely curtail dollar strength.

So overall such political-economy factors argue against a sharp 2017 dollar appreciation, consistent with my base case of a gradual grind up.  And long-dated dollar risk reversals seem to be pricing a similar scenario: while they generally suggest $ upside (except versus the yen) they are not particularly elevated (see chart).

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