The two-day FOMC meeting starts tomorrow and wraps up Wednesday afternoon. We expect another dovish hold, with Powell underscoring that Fed policy is going nowhere anytime soon. With the US economy surging, we suspect the Fed can do little to keep rates down and so the dollar is likely to continue benefitting from rising yields as a result.
Curve steepening is a global phenomenon. The US, Australia, and Norway are leading the pack due to their relatively strong economic performances. However, several major economies are not seeing the same high degree of uncertainty, such as Germany and Japan. One could argue that is due largely to their relative economic underperformance and therefore are the most vulnerable to tightening financial conditions. The UK is somewhere in between these two groups.
POSSIBLE NEXT STEPS
Things have certainly changed since the last FOMC meeting. Back in January, the Fed noted that the pace of economic recovery and employment had moderated and Chair Powell said the path ahead remains uncertain. We are clearly in a much better position now. Powell also stressed that the whole focus on an exit strategy is premature and that it’s too early to talk about tapering and we believe that still holds true now. Below, we look at several moves that the Fed could make this week and in the coming months.
1. Tweak its macro forecasts – VERY LIKELY NOW, LIKELY LATER IN 2021. The Fed last updated its Summary of Economic Projections at the December meeting. The Fed sees steady rates through 2023 and that should not change at this meeting. In light of the accelerated vaccine roll out and aggressive fiscal stimulus, the nearby macro forecasts should be upgraded significantly after modest changes were made in December. The median GDP forecasts from December (September) were 4.2% (4.0%) in 2021, 3.2% (3.0%) in 2022, and 2.4% (2.5%) in 2023 while the median core PCE forecasts were 1.8% (1.7%) in 2021, 1.9% (1.8%) in 2022, and 2.0% (2.0%) in 2023. Note Bloomberg consensus sees GDP growth of 5.5% in 2021, 3.8% in 2022, and 2.4% in 2023.
2. Jawbone yields lower – LIKELY NOW, LIKELY LATER IN 2021. So far, Fed officials have validated rising yields as a sign of the strong US recovery. However, the pace of curve steepening has picked up and we think the Fed may try to act early to prevent this move from getting out of control. Powell should continue to stress that the current rise in inflation is transitory and likely to fade as low base effects fall out. The Fed should take confront in seeing implied inflation rates validating its Average Inflation Targeting (AIT) framework, but the balance looks fragile. Using TIPS breakeven rates, the 5-year has shot higher to 2.57% now, but the 10- and 30-year rates have stabilized around 2.20%. This seems priced to perfection, and any bump higher in these longer rates will likely cause a lot of anxiety for markets.
3. Tweak its forward guidance – UNLIKELY NOW, LIKELY LATER IN 2021. The new forward guidance introduced at last September’s meeting should remain intact. Premature talk of tapering by some of the regional Fed presidents has been thoroughly quashed by Powell, Clarida, and Brainard. Despite the significantly improved US economic outlook, we do not think the Fed will shift its guidance now to validate market pricing for the first Fed hike that is creeping into Q3 2022. For an extended period, Q1 2023 was penciled in but that has shifted to Q4 2022 as US data improved and is now moving into Q3 2022. If that timetable continues to accelerate, the Fed will have to push back more forcefully against any notions of tightening coming sooner rather than later.
4. Operation Twist – UNLIKELY NOW, POSSIBLE LATER IN 2021. For now, the Fed’s asset purchases remain on autopilot with the Fed currently buying $80 bln of US Treasuries and $40 bln of mortgage-backed securities each month. This has led the Fed’s balance sheet to increase to a record-high $7.58 trln in mid-March, an 82% increase from end-2019. Purchases are currently spread out evenly across the maturity spectrum. We believe the Fed’s first line of defense against rising long yields is to shift its purchase more towards the long end whilst keeping total purchases unchanged. However, we are not there yet.
5. Increase asset purchases – VERY UNLIKELY ANYTIME. At this stage of the recovery, it would be very hard for the Fed to justify increased asset purchases beyond it’s already aggressive pace. As it is, the Biden administration appears to have recognized that it will have to lessen its reliance on borrowing to finance its spending. This should not come as a huge surprise, as Treasury Secretary Yellen has already said parts of the upcoming infrastructure bill will have to be paid for with higher taxes. Reports suggest that key Biden advisers are now preparing for a package of measures that could include hikes in both the corporate tax rate and the individual tax rate for high earners. At the margin, this will help lower UST issuance and any potential need for the Fed to absorb it.
6. Introduce Yield Curve Control – VERY UNLIKELY ANYTIME. After some Fed officials toyed with the notion of YCC early last year, there has been nary a mention of YCC in official commentary since the September FOMC decision and the updated forward guidance. Because YCC basically commits to unlimited QE to maintain the target, we do not think the Fed is prepared to go down that road. If perceived improvements in the US economy were to push US yields significantly higher, then we think there would first be the series of QE changes highlighted above. We think YCC would only be seen if these more “traditional” asset purchases fail to halt a disruptive rise in yields.
7. Negative interest rates – VERY UNLIKELY ANYTIME. Not one current FOMC member has advocated negative interest rates. Indeed, minutes from recent FOMC meetings show that the concept isn’t even being actively discussed. Uber-dove and former Minneapolis Fe d President Kocherlakota is the only Fed official that we can recall (past or present) that has advocated for negative rates. Simply put, there is no hard evidence that negative rates work and there is of course risks of lower bank profitability and damaging the financial system. Last summer, Fed Funds futures were pricing in odds of negative rates, but no longer.
At the margin, rising US yields and enhanced Fed tightening expectations should help boost the dollar. Other central banks are likely to follow the Fed in removing stimulus much, much later. We saw a similar dynamic play out during the financial crisis and we see no reason for that to change.
The dollar tends to weaken on recent FOMC decision days. In 2019, DXY weakened on five of eight FOMC meeting days. In 2020, DXY has weakened on nine of ten decision days. This pattern may have changed this year. The dollar gained at the January meeting. If the Fed is unable to shift market expectations away from rising yields at this week’s meeting, then we would expect rates to spike higher and give the dollar further fuel to rise.
The dollar has already resumed its climb. We view recent dollar softness as largely profit-taking and consolidative in nature. As such, we believe DXY is still on track to test the November 23 high near 92.80 and then the November 11 high near 93.208. Longer-term, a break above the 92.628 area would set up a test of the September high near 94.742. The euro is nearing support around $1.19 and remains on track to test the November 23 low near $1.18 and then the November 11 low near $1.1745. Sterling is softer after being unable to break back above $1.40 and is likely to test the March low near $1.3780. Looking further out, a break below $1.3825 would set up a test of the February low near $1.3565. The rise in USD/JPY has resumed and the pair has traded at a new cycle high near 109.35. We believe the it remains on track to test the June 5 high near 109.85 and then March 2020 high near111.70.
We note that the dollar typically does poorly at the onset of each round of QE before eventually recovering. Looking back to the financial crisis, the Fed first started Quantitative Easing (QE) in November 2008 when it announced plans to purchase $600 bln of agency mortgage-backed securities (MBS). DXY fell around 12% over the next month but then recovered to trade even higher by March 2009. QE1 was extended in March 2009 with another round of agency MBS purchases worth $750 bln as well as $300 bln worth of longer-dated US Treasuries. DXY fell around 17% over the next eight months but then recovered nearly all its losses by June 2010.
Why did we turn positive on the dollar back in January? With QE well under way, the stage was set for a strong bounce in the US once the virus was controlled. That has come to pass, along with an accelerated vaccine rollout that is amongst the fastest in the world. In addition, we got the full $1.9 trln stimulus bill passed this month and reports suggest the upcoming infrastructure package will be even larger. What usually turns the dollar around after subsequent bouts of QE is the recovery in the US economy and that’s exactly what we’re getting now in 2021.