As Rabobank’s Michael Every wrote earlier, “today Jerome Powell esquire, Chair of the FOMC at the US Federal Reserve, is going to be in the spotlight once again. The Fed concludes their two-day meeting and will give an updated set of projections, including the ‘dot plot’ of their own collation of expectations for rates. What a tricky task this will prove… The Fed conveniently skipped the March forecast round and left it to others to prepare the public for the awful economic data that we have since seen. They can’t get away with that kind of trick again, surely? Let’s see if they agree with the horrendous expectations that the IMF, World Bank, and even real-time Fed data all hold.“
So before we get into the weeds of how Powell will approach this “tricky task”, here is a snapshot of what Wall Street expects courtesy of NewsSquawk:
- Rates are expected to be left unchanged at 0-0.25%, along with commentary that they will not be raised any time soon.
- It might be too soon to introduce more explicit forward guidance since implied rate pricing is in line with the Fed’s current stance, although data surprises seen over the last three weeks have seen a rise in outright yield levels – particularly along the long-end of the Treasury curve – while market-based inflation expectations have been rising, and pricing for negative interest rates in 2021 has reversed.
- It is also probably too soon for yield curve control, although some speculate that the Fed will roll out some version of short-end YCC, with the Fed likely to keep it in its toolbox until such time it needs to strong-arm market expectations.
- Powell might reign-in some of the market’s recent enthusiasm over expectations of a quick recovery, particularly as the uncertainties around COVID ‘second wave’ and the lack of visibility in current data (no analysts had predicted that jobs would bounce back as they did last week, for instance) requires the Fed to remain cautious and accommodative;
- Updated staff projections are likely to underscore this point.
The pace of the Fed’s daily Treasury/TIPS purchases were running at an average rate of USD 70bln per day in late March, though has now been tapered to USD 4bln per day this week (which equals to roughly USD 1trln per year), and its monthly pace of purchases is now coming into the USD 80-120bln bracket that encapsulates most analysts’ estimates of how much the Fed will eventually set its monthly open-ended purchases at. Analysts note that the US Treasury needs to finance a 2020 deficit of around USD 3.5-4.0trln; the Fed’s purchases since mid-March total around USD 1.6trln, helping to keep rates low to offer the Treasury favourable funding conditions and a backstop to its issuance. Some analysts estimate that around two-thirds of the tightening seen in financial markets from the start of the year through mid-March, and the Fed’s continuing to taper purchases against that background could signal its preference to keep its asset purchases large enough to maintain the current amount of accommodation. Traders will also seek guidance on whether any monthly pace of asset purchases will be subject to pre-announced tapering.
The April meeting minutes revealed some participants wanted to provide more explicit forward guidance versus its current vague commitment. The Fed is not under any pressure to enact this now given that markets still accept rates are going nowhere anytime soon, but the Fed will be cognizant that market pricing may be coming to an inflection point after the better-than-expected incoming data seen in the last three weeks, and more explicit guidance (and YCC, see below) will help avoid the taper-tantrum scenarios seen in 2013. Even if guidance is left vague, Powell may start shaping our expectations on what sort of guidance that the Fed will ultimately decide on. More explicit guidance might take one of three forms: 1) calendar-based forward guidance; 2) target-based forward guidance (inflation, unemployment rate, etc); a blended version would be targeting certain a level with a date to re-evaluate.
YIELD CURVE CONTROL:
Some expect the FOMC to eventually introduce yield curve control – setting a target level to cap short-dated yields in order to bolster its commitment that rates will be kept at low levels for the foreseeable future; but this might also not be necessary at this stage, given that futures are not pricing any rise in the Federal Funds Rate (FFR) over the next couple of years, while shorter-dated yields below 2-year maturities are already under the top-end of the FFR target. Shorter-dated yields have been anchored by monetary policy expectations, which the Fed will be pleased about. However, it will be mindful that after last week’s economic data, yields in the belly and the long-end of the Treasury curve have risen, while the non-zero probability of negative rates in 2021 has also reversed; this suggests participants are becoming more constructive in their view of the economy, perhaps hinting at less need for long-term accommodation from the Fed. To what extent the Fed leans back against that notion at the June FOMC will be crucial for the shape of the yield curve, which has been steepening significantly.
STAFF ECONOMIC PROJECTIONS:
Powell will likely emphasize that the forecasts are subject to high degree of uncertainty. We will not know how each participant factored in assumptions of fiscal support (next tranche expected around the USD 1trln size), or political/geopolitical uncertainty (US/China tensions have been increasing), and even how COVID plays out (is a ‘second wave’ priced into forecasts, how many people will be recalled from furlough, how many will want to return). However, there is building evidence that the economy is bouncing back in a more quickly than had been previously assumed likely after recent data points, and the forecasts will allow us to see if the Fed is giving credence to that notion; the key to focus on for traders will be to compare the end-2020 vs end-2021 projections to see how quickly the Fed expects unemployment to fall; before last week’s jobs report, Fed’s Kaplan thought the jobless rate would fall to 10-12% by end-2020, falling to around 7% by the end of 2021; the CBO in April forecast that the unemployment rate would fall to 11.7% in Q4 2020, and then to 10.1% in 2021 Meanwhile, the Fed’s inflation forecasts will usually show a return to target in the long-term. The uncertainty will likely keep the Fed’s approach flexible, which will mean it probably delivers cautious projections which envisage a slow recovery.
POWELL PRESS CONFERENCE:
The Fed chair will need to balance caution and not sounding too downbeat on the progress made. He will likely reiterate that the pace of recovery will be slow, and the Fed stands ready to step in as appropriate to provide support. However, Powell has already said that he is mindful of the ‘second wave’ of COVID cases, and that will likely keep his tone caution amid that uncertainty, with many expecting him to strike a dovish tone. Powell has previously argued that inflation risks are to the downside – it will be interesting to see what he makes of the incoming data, and particularly, how market-based inflation assumptions have also risen. There may be questions on whether the Fed did too much too quickly, given the economic surprises seen over the last three weeks; however, in the Fed’s defense, visibility was obviously poor at the time, and the central bank erred on the side of being overly accommodative rather than risking not being accommodative enough – Powell has previously alluded to this. This will naturally give rise to debates around whether the Fed should be scaling-back its largesse via either less bond buying, or even bringing in some of the new programmes designed to help businesses through the crisis. For traders, it is crucial to see what extent Powell acknowledges this debate – any explicit acknowledgement may signal less accommodation to come in the future, although it is expected that the Fed chair will indicate that the Fed measures were appropriate and its stance will remain accommodative for some time.
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With those big picture considerations in mind, here is what Goldman thinks will be announced today:
- Recent comments from Fed officials suggest that major policy changes are unlikely at the June FOMC meeting this week. But a new set of projections and Chair Powell’s press conference should provide some insight into future policy intentions.
- Since the FOMC met in April, the process of reopening the economy has proceeded smoothly. Consumer activity has started to pick up, the labor market has begun to recover sooner than expected, and financial conditions have continued to ease. The FOMC statement is likely to acknowledge this progress while emphasizing that economic activity remains depressed.
- The Summary of Economic Projections will return next week after a hiatus in March. We expect participants to show an elevated unemployment rate and below-target inflation through the end of the forecast horizon in 2022, despite expecting strong growth in coming years.
- All or almost all FOMC participants are likely to project a flat funds rate path through the end of the forecast horizon in 2022, implying that liftoff is likely to come only at a later date. We expect the median longer run or neutral rate dot to decline by 25bp to 2.25%, following the decline in distant forward interest rates.
- We expect the FOMC to take three major steps down the road, likely at the July or September meeting. First, we expect a transition to a traditional asset purchase program with a steady pace of around $80bn of UST and around $40bn of MBS net purchases per month. Second, we think the FOMC is likely to introduce outcome-based forward guidance that delays liftoff roughly until the economy reaches full employment and 2% inflation. Third, we expect the FOMC to reinforce its guidance with front-end yield curve control, capping interest rates out to a horizon somewhat short of the date when the Committee forecasts its liftoff criteria will be met.
- We have revised our labor market forecasts following the May employment report. We now expect the unemployment rate to fall to 10% at the end of 2020 and 7.5% at the end of 2021.
Goldman also expects the FOMC’s projections to be revised as follows:
- On growth, we expect participants to show a sharp decline of roughly 4% Q4/Q4 this year (vs. GS -3.4%), followed by a strong rebound in 2021 and another year of well above trend growth in 2022. We think the longer run growth projection is somewhat more likely than not to decline by one-tenth to 1.8%, reflecting some lasting damage from the current crisis.
- On the unemployment rate, our own forecast following last Friday’s employment report now ends 2020 at 10% and 2021 at 7.5%. The FOMC is likely to show a similar path, with an elevated unemployment rate all the way through the end of the forecast horizon in 2022. Some participants might see a case for raising their estimates of NAIRU—essentially a story of “mismatch” unemployment, with occupational groups such as waiters and flight attendants in the most virus-affected industries today playing the role of construction workers in 2008—but we suspect that most will keep their estimates unchanged, taking a lesson from the low inflation alongside low unemployment over the last couple years.
- On inflation, we expect the FOMC to show core PCE at 1% at the end of 2020 (vs GS 0.8%), followed by a gradual pick-up to still noticeably below-target levels through the end of the forecast horizon in 2022. A number of Fed officials have said recently that the virus shock is likely to be disinflationary on net, and that concerns about high inflation are unwarranted,
On the “dots”, Goldman also predicts that all or almost all FOMC participants are likely to project a flat funds rate path through the end of the forecast horizon in 2022, implying that liftoff is likely to come only at a later date. Several Fed officials have noted in recent weeks that both their expectations and market expectations are for the funds rate to remain at the lower bound “for some extended period of time,” as President Kaplan recently said.
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Going back to Michael Every, the Rabobank strategist predicts that the Fed is likely to focus on forward guidance on rates and asset purchases: it is a given that rates are on hold until normal economic service has been resumed, and then some, and also that the FOMC will continue to expand its special lending facilities even further despite the fact that the worst of the economic downturn is already behind us. However, the markets are only really going to be focused on four things:
- One, will the Fed open the door even a crack to negative rates? The Fed does not seem to be in a hurry to tweak the IOER rate, even though that would help reduce the occurrence of negative implied Fed Funds rates and thus quell some of the speculation about negative US rates in our view. However, despite market chatter we believe that European- and Japanese-style negative rates are a no-go for the Fed.
- Two, will we see Yield Curve Control (YCC)? If so, which parts of the US Treasury curve will, Japanese- and Aussie-style, cease to function as a real market? Would it just be the short end of the curve? That leaves the door open for curve steepening of the kind seen in recent sessions, which carries the risk of real pain for borrowers. Moreover, with the massive expansion of US Federal debt, YCC out to 2 years would mean issuance at the short end and constantly having to roll it over. In other words, raising the Fed Funds rate again would not be possible until public debt was under more control – which realistically means never. Or might YCC be longer, say out to 7 years? This would give greater room to spread the looming trillions that will flow, and perhaps enough time for some optimists to presume an economic turn-around within that period is possible. Yet could we even see that financial totem of all totems, the US 10-year, under YCC? If so the global debt benchmark is not looked at, but sat on like a bench. Japan is already doing it.
- Three, can the Fed manage to do either of the above without the US Dollar falling out of bed? The structural bull argument for USD is still there, but current momentum is such that hinting at negative rates and/or pegging US yields could easily push it down. The Fed aren’t responsible for the USD, but they certainly know that is true. The question is whether they are either desperate enough about the outlook not to care, or are happy about a currency weakness they can pretend is nothing to do with them. Hello FX Wars! Join the queue behind the trade war (as China cancels some shipments of US goods already en route) and the Cold War (as the US senate de facto opens the door to banning all Chinese telcos from the US market). That said, there is also an emerging argument –one we have put forward since 2017– that in a Cold War it is a strong USD and not a weak one that is the greater US weapon. There is still unlikely to be a line of communication between China hawks in DC and the Eccles Building where the FOMC sit, but it’s still worth remembering what the geopolitical backdrop is.
- Four, can the Fed find a way to do even more than it already is without encouraging what many see –even by the standards of the mind-blowingly stupid examples around the word in recent decades– as an epic, lunatic, *dangerous* stock-market bubble? Indeed, can they do so without stocks tumbling down on top of the retail money arriving late to the party? “Excessive exuberance”: anyone recall how many years and bubbly Fed Chairs ago that was?
Finally, looking at the actual FOMC statement, it is likely to acknowledge the early signs of progress in the timeliest consumption and labor market data, while also emphasizing that economic activity remains very depressed. Goldman expects changes along these lines in the second paragraph of the statement with the rest left largely unchanged, as shown below.