Treasuries Mark Time Until Afternoon Fed Rate Hike

Jun 13, 2018

Treasuries are marking time until the 2pm EDT Fed rate-hiking announcement with  most maturities at or near unchanged on the day. We expect that to remain the case until the afternoon announcement (more on our expectations below). In the meantime, with the Singapore summit with North Korea now completed the market’s reaction has been somewhat muted. That probably has to do with the somewhat vague nature of the communique that was signed. The market took a few ticks out of the risk-off trade for good measure and will wait and see what else transpires from the get together. That seems about right to us, and while we certainly applaud efforts to reduce the risks of armed conflict, vague announcements and peace-wishing platitudes are but a first step. We’ll wait for more concrete steps to follow before altering our trading posture off the meeting.


  Economic News


The market is navigating a week replete with all manner of top-tier influences without too much volatility so far, but that might change this afternoon when the FOMC releases it’s rate decision at 2:00pm EDT. While a 25bps rate hike is a given, the drama will be whether the rate forecast moves higher versus the March forecast. Recall the March forecast still had three hikes for 2018, same as the December forecast. However, it would take only one of the six members who called for three 2018 hikes in March to increase their June forecast to move the median to a four-hike 2018 scenario. Thus, there is some drama over that possibility.


If we do get a four-hike 2018 median in the refreshed forecast today, and we think we do, that will pressure the yield curve flatter as the short-end is still priced for barely three hikes (current year-end market expectation is 2.24%). The market impact of a four-hike scenario in 2018 could be attenuated if 2019 and 2020 year-end forecasts remain the same as March in a pulling forward of their previously planned hikes.


Also, there is quite a bit of chatter that the Interest on Excess Reserves (IOER) will be clipped 5bps as the effective rate has been drifting towards the upper bound instead more comfortably in the middle-ranges. Thus, we might see IOER move to 1.95% this afternoon instead of the 2.00% upper bound. That would effectively be a 20 basis point hike and not 25 which may soften the market’s reaction to a hawkish Fed statement and outlook that otherwise might be treated more bearishly.


The unemployment forecast is another element that is likely to see some revisions. The March projections had the unemployment rate ending 2018 at 3.8%. We hit that in May. The March forecast had unemployment bottoming in 2019/20 at 3.6% before lifting to a long-term level of 4.5%. It’s likely they will move the 2018 forecast down to 3.6% matching the March 2019/20 forecast but will they push that lower? And will they push the long-term rate lower as well? If anything, it’s this low unemployment level that may give the Fed confidence to move to a four-hike 2018 but will they also acknowledge the equilibrium unemployment rate is likely lower than the 4.5% rate they projected in March given the docile wage growth rates we’ve seen?


It will also be interesting to see if the Fed makes any mention of international concerns. We speak here of the potential trade wars and the impact that could have on economic growth, the Italian question in Europe, and also the strains that are becoming evident in emerging markets. First it was the depreciation in the Turkish Lira and then troubles appeared in Argentina and Brazil. The nature of these emerging market crises are to spread from one country to another and we appear to be seeing the early stages of it again. Adding an additional rate hike into 2018 certainly wouldn’t help these economies.  


We’re inclined to think the Fed will make only an oblique mention such as “monitoring international developments” so as to alert Fed watchers they are on the case but not make too big a deal about it at this meeting. Thus, we think the Fed delivers on the 25bps rate hike, shifts to a four-hike 2018 scenario but leaves the March forecast of a terminal rate of 3.5% and long-run equilibrium rate at 2.875%. That , plus the clipping of the IOER rate will soften the blow of a four-hike median for this year (2.25%-2.50%), but should still rally the dollar, flatten the curve and cause the 10-year to test 3.00% once again.


The other element in the Fed’s mandate, price stability, received updated information just as the Fed began it’s two-day FOMC meeting. The May CPI report released yesterday found the overall and core index increased 0.2% for the month, as expected, with year-over-year gains totaling 2.8% and 2.2%, respectively, again matching expectations. The annual gain in the overall index was the largest since February 2012 while the core’s annual increase was the largest since May 2017.


While the yearly gain numbers look impressive, those reflect impressive energy (read oil and gas) gains more than anything and should stabilize with oil retracing earlier gains since mid-May. What’s more, the more important monthly core gains remain modest of late with last month’s gain at 0.17% and April at 0.098%. Also, the 3-month annualized core rate is running at 1.8% for the past two months. Once again, it was shelter expense at 0.3% that paced the core gains with little broadening into other sectors that we, and the Fed, are looking for in order to generate a more durable pick-up in inflation. Bottom line, however, is the gains are sufficient to provide yet another reason for the Fed moving to a four-hike 2018 scenario. We’ll be back after the announcement with a review of the Fed’s actions and updated forecasts.



Market Update  Year-End Fed Funds Forecast Still Sees 3 Rate Hikes


The FOMC will conclude its two-day meeting this afternoon and raise the fed funds rate by 25bps but the real question is do they raise their forecast to a four-hike 2018 scenario from the three-hike scenario currently in place? As shown, the graph of fed funds futures has been climbing without much break since September 2017 but at 2.24% it is still reflecting a three-hike 2018 scenario. If, as we expect, the Fed ups the forecast to a fourth hike, expect the short-end of the curve to sell-off and yields increase to adjust to this additional hike. That will flatten the curve with the 2yr-10yr cycle low spread of 42bps in danger of flattening further. 


Year-End Fed Funds Forecast Still Sees 3 Rate Hikes



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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