The FOMC concludes its June meeting today and that means the market will mostly mark time until 2pm ET when the statement hits the wires. The question everyone awaits is how dovish will the Fed be now? While the Fed has managed to provide some type of dovish surprise at every meeting this year the only way to do that today would be to cut rates, but the solid May retail sales numbers—and positive April revisions—most likely dash those hopes. While we expect the Fed to move from a patient pause approach to one leaning towards easing —setting up a July or September rate cut— that modest response may initially disappoint a market that has priced in 75bps of rate cuts by year-end. The market’s reaction may result in selling pressure on the short-end while the long-end may rally as the market perceives the Fed’s response as insufficient in light of moribund inflation pressures, slowing overseas economies, and increasing geopolitical risks. We explore our Fed expectations in more detail below and what that is likely to mean for yields, both short and long-term . Also, we’ll be back this afternoon with a recap of today’s meeting.
The big event of the week arrives this afternoon with the FOMC rate decision and this meeting is easily the most consequential of the year. As we mentioned above, while the market has anticipated a dovish Fed since the patient pause pivot in January, the Fed has still managed to be more dovish than market expectations at the three previous 2019 meetings. That feat may be more difficult to navigate today. One clear way to deliver that surprise would be to cut rates at this meeting, but we suspect that’s a bridge too far for Powell and Co.. Instead, the Fed is likely to demonstrate through both revised forecasts, post-meeting statement and press conference a shift to an easing posture versus the patient pause approach and thus set-up a July and/or September rate cut.
The hesitancy to deliver a rate cut at this meeting is buttressed by several elements. First, the consumer continues to spend at levels that seems likely to deliver a second quarter GDP that comes close to current estimates of 1.8%-2.0%. Coming on the heels of a surprising 3.1% first quarter GDP, the outlook is that the economy is on course to meet the current full-year estimate of 2.1%. Second, as illustrated yesterday, merely the suggestion by President Trump that he had a productive phone call with Chinese President Xi ahead of G20 meetings elicited a risk-on rally that a trade deal is in the offing. That reaction illustrates the volatility linked to trade, but should a deal materialize the Fed will like wise in resisting a rate cut today. Third, with equities still within hailing distance of all-time highs, the extreme volatility we saw in December has not returned and that probably gives the Fed some time before instituting rate cuts with financial conditions remaining generally accommodative.
For sure the Fed does have plenty to worry about with the more dovish members no doubt antsy to move more definitively at this meeting. For example, despite the risk-on stock rally yesterday Treasuries rallied as well off weak euro-area economic numbers and ECB President Mario Draghi promising additional stimulus (i.e., rate cuts and more quantitative easing) if inflation results and expectations don’t start to lift. That promise of more accommodative action, just prior to the Fed meeting, had some conspiracy theorists predicting a coordinated easing by the major central banks may be afoot.
Conspiracy theories aside, the Fed does have its own inflation problem to ponder. The “transitory” label of low inflation seems likely to be axed from today’s statement after CPI and other price measures have continued to resist the siren song of the 2.0% target. Thus, expect to see more concern expressed, not only about persistently low CPI/PCE, but other market-based and consumer inflation expectations that are trending lower. If there is one reason doves will cite to cut rates today it’s the trend in inflation expectations, so expect that to get attention both in the statement, and press conference.
Moving on to the updated economic forecast, the March 2.1% full-year GDP forecast could be cut slightly to 2.0%, in order to give reason for the shift to an easing posture. Inflation expectations seem likely to be cut as well from the 2.0% March forecast to something around 1. 8%. Meanwhile, the dot matrix presents its own challenges. While the March forecast had a single rate hike in 2020, today’s is likely to remove that, signaling the 2.25%-2.50% range represents the cycle high. But will they signal rate cuts this year, or 2020, or 2021? If so, the market may say if that’s what you see why not get on with it now? It’s a conundrum dating to the origins of the dot plot which was born in a stable to rising rate world. It wasn’t designed to handle a rate-cutting world. Expect Powell to downplay the dot plot results today, but expect the market to take note just as well.
In summary, while a dovish message seems certain, it may not be dovish enough to assuage a market expecting 75bps of rate cuts this year and that could lead to temporary selling in short-end maturities while the long-end could continue rallying, perhaps to a 1-handle 10-year, as the market perceives a Fed moving too tentatively. In any event, we will be back with a summary of the meeting this afternoon.
Inflation Expectations Trending Lower
Last week we highlighted the declining trend in Treasury Inflation-Protected Security (TIPs) inflation expectations. TIPs investors receive a CPI-based inflation payment, in addition to a modest coupon, so the pricing of TIPs provides a view of investor inflation expectations. We added two additional series with the Univ. of Michigan Consumer Sentiment Inflation Expectation for both the 1-year and 5yr-10yr periods. The Fed often speaks of “anchored” inflation expectations so the sudden drift lower in both the TIPs and consumer expectations will be concerning. When the Fed eventually cuts rates expect these declining inflation expectations to be cited as a key reason.
Agency Indications — FNMA / FHLMC Callable Rates
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