With equities, bond yields and federal funds target rate expectations collapsing, FOMC expectations are changing daily, Standard Chartered’s Steve Englander writes overnight describing prevailing market sentiment as “fear and loathing in asset markets.”
Yet with economic data reasonably strong, investors are trying to gauge how the FOMC will balance asset market fears and softening growth abroad against still-robust incoming economic data, which the NYT profiled overnight.
Investor perception is that the FOMC will back off sharply from the hawkish stance of September/October, but there is a recognition that the Fed is reluctant to make big policy shifts based on asset markets and foreign growth. Amusingly, as Englander writes, “the FOMC is aware that there are more 130/30 long/short funds than 30/130 long/short funds.”
In terms of how the Fed will achieve the gradual lowering of its dot plot, Bank of America expects the dots will shift lower by 1 hike across the forecast horizon, with the median shifting to 2 hikes for 2019 vs. 3 hikes previously. If newly appointed Governor Bowman is in the 3 hike camp, then we would need 2 Fed officials to shift from 3 to 2 hikes in order to move the median. If Bowman is a 2-hiker – which is possible given that she is a community banker who may naturally lean more dovish- we would only need one additional member to revise down. In our view, the potential candidates to shift their views are Powell, Williams, Evans and Brainard.
Looking further ahead, BofA notes that the story for 2020 is less clear, stating that the bank’s baseline is that the median expectations will be for one hike in 2020 but it is possible that we see a shift up to 2 hikes. If so, it would show that Fed officials are maintaining the same terminal rate but expect to get there slower given the lack of inflation pressure which allows the Fed to slow the cycle. Incidentally, it is the opinion of BofA’s chief economist Michelle Meyer that removing one additional hike is more dovish than if the Fed just pushed it forward.
Even with a dovish move in the short-end, BofA does not expect the long-run dot to move. It has gradually shifted higher over the course of this year and the bank does not think we have seen any evidence to suggest that expectations have moved too much in this respect:
The long-run dot is sticky and it would be surprising if we saw a rapid reversal. However, the risks are for the median dot to shift lower as it would only take one dot to move down from 3% or Governor Bowman to pencil in a long-run rate that is below 3%.
That said, on the economic outlook BofA expects downward revisions to headline and core PCE inflation projections for this year reflecting the decline in energy prices and the relatively weaker string of core PCE inflation prints of late. Looking ahead, Meyer thinks that the growth and headline inflation forecast for 2019 are likely to be revised modestly lower and there are risks to the downside for the core inflation forecast.
So going back to what the market expects, here is how Englander frames consensus:
- Few investors think the FOMC can back off a December hike
- Two 2019 hikes in the dot plot, nothing beyond
- Significant changes in the statement language to indicate a pause is likely after a small number of hikes
- Once neutral is hit, any hikes become very conditional on strong inflation and activity outcomes
There is some debate on whether this “consensus” would be considered sufficiently dovish given current economic and asset market fears and the Std Chartered strategist suspects that it will work to calm markets, but possibly not immediately. It is likely that investors will ultimately be convinced by the Fed’s stress on conditionality of future hikes, but two hikes in the dots may be read in the short term as Fed indifference to market conditions.
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The ultimate dovish market reaction is based on the following logic. Markets now price in only 17bps of hikes for 2019 and 8bps of easing for 2020 – investors tend to view the Fed dots as reflecting a relatively optimistic scenario. Two 2019 hikes in the dots would be read as saying – “three hikes are likely out; two are aspirational but possible; the Fed would settle on one if economic outcomes show ambiguity, but do not suggest it has to stop altogether.”
This is likely acceptable in terms of market pricing. If the Fed points to c.2.87% as the peak of the FFTR (hiking on Wednesday and twice in 2019) and stresses conditionality, market pricing of 2.5-2.6% for a FFTR peak is reasonable. That would still seem to leave room for US long-term yields to come down from current levels of 2.84%.
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