While The Fed is a "motivated rate raiser," it appears that they are losing confidence in their growth forecasts, which means, as Goldman Sachs notes, another downgrade to the long run rate tomorrow, bringing the cumulative reduction in the Fed’s tightening cycle over the past year to 75 bps. There is a good chance the market will see this as a signal to sell the Dollar, on the grounds that the Fed will look increasingly uncertain over the medium-term trajectory of policy.
It appears the dollar is starting to sold on this expectation…
It's FOMC day, and against what Bloomberg's Richard Breslow is sure is their most fervent wish, they will have to issue a statement and the Chair manage a press conference, adding that he "suspects it'll be an exercise in conditional statements worthy of the best freshman logic class."
At least we don’t have to maintain the fiction that this was a “live” meeting. Data dependence actually gets them off the hook of even thinking of committing the policy mistake of raising rates ahead of next week’s U.K. referendum. But don’t think they’re going to give up on two possible hikes this year without a fight.
The market has been more right on the economy and global outlook than the Fed’s forecasts. It’s why the communication calamity that’s been the dot plots has helped damage their credibility. It wasn’t Fed Funds future traders who treated the latest guesses as the party line.
But make no mistake, the Fed is a motivated rate raiser. If the June employment report shows any return to form and the world hasn’t fallen apart, then futures are mispricing not only the Committee’s intentions, but the most likely level of rates at year-end.
Hidden deep in the Treasury-feeding frenzy has been some really chunky Eurodollar futures put-spread buying. Betting on a more aggressive rate trajectory. On Tuesday alone, someone splashed out $27.5M in premium to express that view. More was bought yesterday.
Analysts keep telling us to focus on the long-term dot plots. It’s irrelevant what they pretend to think about 2017 or beyond. They do have a fighting chance of sussing out the next six months.
Non-farm payrolls aside, the numbers have been good enough. GDP appears to have bounced smartly. Yesterday’s retail sales and import prices will brighten the mood around the table.
This hasn’t been a lucky or opportunistic FOMC. They’re going to have to learn to seize the day when conditions allow.
But as Goldman Sachs explains, that will not be today, or perhaps even July, as the focus of attention for this meeting will be the long-run "Dots"…
1. As Fed monetary policy normalization has gotten underway, there have been two kinds of FOMC meetings:
(i) those that have scaled back expectations for hikes in the near term, while keeping the long run target for the Funds rate unchanged; and
(ii) those that scaled back the overall size of the tightening cycle, reducing the long run target for the Funds rate.
In previous FX Views, we argued that it is the overall size of the hiking cycle that matters for our Dollar view and so we will be closely watching the long run rate in tomorrow’s Statement of Economic Projections (SEP). If, as our economists expect, the long run target falls by 25 bps to three percent, this would be the third time that the long run target rate has been cut since September 2015 and could signal that the Fed is gradually losing confidence in the kind of tightening cycle that history demands, in line with a recent FX Views where we argued that China’s RMB problem may be causing the Fed to be more dovish all else equal. If there is such a reduction in the long run rate, we see scope for the Dollar to weaken somewhat further tomorrow, even with Fed Funds futures pricing less than two hikes over the next two-and-a-half years. If, instead, the long run rate remains unchanged, this could signal a Fed that is not re-evaluating its basic framework for policy normalization and could see the Dollar rally in coming weeks, especially if uncertainty around the British referendum is resolved in favor of a “remain” outcome.
2. The Dollar on a trade-weighted basis versus the majors is close to the bottom of its range since March 2015 (Exhibit 1). Looking forward, the path for the Dollar depends on prospects for additional easing from the ECB and BoJ, both of which are still way behind the curve on meeting their inflation mandates, and on the magnitude of the tightening cycle in the US (Exhibit 2). Our US team continues to see the terminal Funds rate at 3.4 percent, meaning that the tightening cycle will be another 300 bps from here (through Q3 2019). Given how little tightening is priced into Fed Funds futures, it is at first glance difficult to see how the Fed can deliver a dovish surprise, but we are more cautious going into tomorrow. This is because our Dollar view rests on our expectation of a tightening cycle similar to what was the norm historically. If, instead, the Fed signals that it is losing confidence in such a cycle, by downgrading its long run expectation for the Funds rate, this could cause the Dollar to weaken somewhat further.
Exhibit 3 shows the median “dot” for Fed meetings since Dec. 2014, which have come in two basic flavors.
The first postpones the tightening cycle, but keeps the overall size of the cycle unchanged. The Fed meeting in Mar. 2015, after the Dollar had risen very sharply, is a good illustration. In hindsight, the Fed was probably spooked by the rapid pace of Dollar appreciation and decided to step on the brakes a bit. It did not, however, change its underlying view of how much tightening would be needed, keeping the long run target for the Funds rate at 3.75 percent.
The second downgrades the overall size of the tightening cycle, with Sep. 2015 and Mar. 2016 being examples. Notably, both of these came after episodes of pronounced RMB uncertainty, potentially causing the Fed to re-assess just how much tightening is possible for the overall Dollar-block, something that Andrew Tilton also emphasized recently.
Our US economists expect another downgrade to the long run rate tomorrow, bringing the cumulative reduction in the Fed’s tightening cycle over the past year to 75 bps. There is a good chance the market will see this as a signal to sell the Dollar, on the grounds that the Fed will look increasingly uncertain over the medium-term trajectory of policy. Conversely, the Dollar could rally should the long run Funds rate remain unchanged, since this signals confidence in the medium-term trajectory of policy.
3. There are obviously many other dimensions that may play a role tomorrow. The June FOMC meeting a year ago may provide a good template. The number of dots for one hike or less jumped from three in March to seven in June, a sufficiently large move to signal a dovish shift (even with the median unchanged). Our US team does not believe that the median “dot” falls below two (Exhibit 4), but the number of dots shifting to only one hike in 2016 is obviously important. They expect only four dots to shift from two to one hikes, anything more would likely also surprise the market in a dovish way.
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Finally here is an alternative 'even more hawkish' perspective…
"I know a lot of Wall Street thinks [Yellen] is going to be very dovish," said David Nelson, chief strategist at Belpointe Asset Management, based in Greenwich, Conn.
"I think she's going to be more hawkish than people expect. I think she wants to keep [a July rate hike] alive and she wants to keep the market a little bit off balance because it would indicate that things are falling apart if she adds dovish commentary."
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