What We Think the Fed Delivers This Afternoon

Sep 26, 2018

The market awaits the Fed rate hike this afternoon, but more importantly it awaits the updated economic and rate forecasts. With a 25bps rate hike baked-in, the only suspense is whether the Fed increases the number of future rate hikes or accelerates the expected pace of hikes. We think they paint a more optimistic economic forecast that allows them to increase the expected pace of hikes and/or nudge the 3.375% terminal rate projected in June by another 25bps.  The Treasury curve is likely to resume its flattening trend off the Fed news as the short-end remains under pressure from the increased pace and/or number of future hikes. Meanwhile, the long-end, having toyed with year-to-date high yields this week, could very well rally on the thought the Fed may tighten too much as economic growth moderates after the sugar-high of tax cuts and increased deficit spending of 2018. In fact, since September 2017, 10-year notes have sold off the day before every quarter-end Fed meeting. On the day of the meeting and the next day yields typically rallied or held. Given the selling leading up to this meeting we very well could see that same pattern emerge and the 10-year is up 3/32nds to start the day with a yield of 3.086%.


  Economic News


We’ve mentioned in recent Market Updates that we expect the FOMC rate decision later today to be a “hawkish hike.” What we mean by that is that not only will the Fed hike the fed funds rate by 25bps today, but they are also likely to deliver a forecast/guidance that spells out more rate hikes than had been the case in previous forecasts. What that means for rates is a likely continuation of a flattening yield curve with the short-end remaining under pressure from Fed rate-hiking guidance while longer maturities test support levels but remain more range bound.


This meeting, falling on a quarter-end, provides us the full panoply of Fed guidance. We’ll get a new Summary of Economic Projections (GDP, Unemployment, Inflation) and we’ll also get an updated Dot Plot of future fed funds rate expectations with a peek at 2021 expected levels for the first time. Overlaying all that will be a press conference by Fed Chairman Jerome Powell.  


Reading the tea leaves and tone of recent Fed speeches, scanning economic results, and yield curve positioning, we fully expect the Fed to provide a more optimistic take on the economy versus the June forecast. In addition, a recent speech by influential Fed Governor Lael Brainard expressed the view that hiking rates beyond the perceived long-run neutral rate  (currently estimated at 2.75%-3.00%) could be necessary given the momentum in the economy. The fact that it was Brainard, a previously dovish Fed member, espousing this view adds credibility to the belief that the central stance of the Fed had shifted to a more neutral-to-hawkish position than the previously dovish-to-neutral position that had characterized the Yellen-led Fed.


What we are likely to see this afternoon, in addition to a rate hike, is an economic forecast that projects GDP at levels above those in the June forecast (2018-20 GDP was forecast to be 2.8%, 2.4%, 2.0%, respectively).  In addition, the long-run rate of unemployment (currently estimated at 4.5%) is likely to be knocked lower in a nod to the reality that we’re nearly 100bps under that rate with only a modest uptick in wage inflation. Given the expectation that the dot plots will project a faster pace of hikes and/or a higher terminal fed funds rate (currently estimated at 3.25% to 3.50%), it’s not likely the Fed will materially move their inflation forecasts which in June called for the core rate to trend around 2.0%-2.1% for the next few years.


As we mentioned, if our expectation comes to pass it’s likely to pressure the short-end which will have to adjust to the faster and/or higher expected fed funds rate path. Longer maturity yields, meanwhile, may initially rise as the higher economic forecast gets attention. Thus, we wouldn’t be surprised to see the year-to-date highs in the 10-year (3.11%) and 30-year (3.25%) challenged in that scenario. In the longer-run, however, we suspect any breach of these support levels could be short-lived as the market realizes that the Fed could very well be positioning to tighten too much in the face of emerging market struggles that are creating deflationary forces, still-developing trade/tariff impacts, a plateauing housing market, and a dulling impact from the tax cuts. All of those issues will play out over a long-run horizon but investors may interpret their impact quickly and limit any back-up such that a flat-to-inverted curve becomes a reality later this year.


A good example of the conflicting data that now confronts us yesterday’s Consumer Confidence Index printed at 138.4 versus 132.1 consensus and 134.7 in August, the highest level in 18 years. In addition, the present situation assessment hit a new cycle high at 173.1, from 172.8 prior, and is on pace to match the July 2000 all-time high early next year. In all, a very strong report that is consistent with the notion the economy is strong enough to justify additional Fed tightening in quarters to come. On the other had, the S&P Corelogic Case-Shiller Home Price Index for July rose 5.92% YoY versus 6.20% expected and 6.36% prior, slowing for a fourth consecutive month with growth at the weakest pace since August 2017. This provides further evidence that the domestic housing sector is slowing. The question is how will Fed Chair Powell address this tomorrow during the press conference. Will it be characterized as ‘transitory’ or something more concerning?



Market Update  Fed Funds Dot Plot Likely to Shift Higher Today


FOMC meetings that coincide with a quarter-end are always the most interesting as they come with updated economic and rate forecasts in addition to the post-meeting statement.  Today’s forecasts are likely to show a shift higher in economic expectations versus the June numbers and that could also mean a shift higher in fed funds rate expectations. The graph shows the June forecast with the green line connecting the median level of expected fed funds rates out to 2020 at 3.375% and the longer-run rate at 2.875%. At this meeting the Fed will reveal its 2021 expectations for the first time and the longer-run rate beyond  2021. The market will be focused on the 2021 rates and the longer-run rate for hints that the Fed expects a more aggressive rate hiking schedule.


Fed Funds Dot Plot Likely to Shift Higher Today



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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