The two-day FOMC meeting starts tomorrow and wraps up Wednesday afternoon. We expect a hawkish hold stemming from a shift in the Dot Plots, upgraded economic forecasts, and potential tapering talk. With risks to U.S. yields weighted to the upside, the dollar is likely to benefit from any bond market repricing of the Fed and inflation outlooks.
U.S. rates remain low as we enter a crucial week for the bond market. Despite ongoing upside surprises in inflation, the 10-year yield is trading around 1.48% currently after trading as low as 1.43% late last week. There are many factors being cited with regards to the ongoing UST rally: strong foreign demand searching for yield, strong domestic demand from fully-funded U.S. pension funds, heightened confidence in the Fed, and abundant liquidity as the Treasury reduces its cash balances at the Fed. We suspect it is a combination of all these and then some. Yet when all is said and done, it is hard to justify U.S. yields remaining this low for much longer. There are plenty of potential triggers this week for a reversal in yields.
POSSIBLE NEXT STEPS
Things have shifted since the last FOMC meeting. Back in April, the Fed noted that the pace of economic recovery and employment had strengthened. From the FOMC statement: “Amid progress on vaccinations and strong policy support, indicators of economic activity and employment have strengthened. The sectors most adversely affected by the pandemic remain weak but have shown improvement. Inflation has risen, largely reflecting transitory factors.” Since the April meeting, we have gotten two months of disappointing jobs data and two months of higher than expected inflation readings. Below, we look at several moves that the Fed could make this week and in the coming months.
1. Tweak its macro forecasts – LIKELY NOW, LIKELY LATER IN 2021. The Fed last updated its Summary of Economic Projections at the March meeting. The median GDP growth forecasts were 6.5% in 2021, 3.3% in 2022, and 2.2% in 2023 while the median core PCE forecasts are were 2.2% in 2021, 2.0% in 2022, and 2.1% in 2023. Unemployment is now seen at 4.5% in 2021, 3.9% in 2022, and 3.5% in 2023. So, according to the Fed’s latest projections, it will have met its dual mandate by the end of 2023 but no rate hike is seen until 2024 at the earliest. Note Bloomberg consensus currently sees GDP growth of 6.6% in 2021, 4.1% in 2022, and 2.3% in 2023 and core PCE inflation of 2.5% in 2021, 2.2% in 2022, and 2.1% in 2023. We expect the Fed forecasts to move towards market consensus.
2. Tweak its Dot Plots – LIKELY NOW, LIKELY LATER IN 2021. In the March Dot Plots, the Fed’s median projection still saw steady rates through 2023. However, there was a notable shift beneath the surface. 14 of 18 members saw no hikes through 2022 and 11 of 18 members saw no hikes through 2023. Back in December, 16 of 17 members saw no hikes through 2022 and 12 of 17 members saw no hikes through 2023. Christopher Waller became the 18th member of the FOMC when he was confirmed back in January. That shift is likely to continue at this meeting. If we did our math right, it would only take 3 FOMC members to shift their 2023 expectations from no hike to 1 hike to get the median to move forward to 1 hike that year. This seems quite possible. Likewise, it would take 6 FOMC members to shift their 2022 expectations from no hike to 1 hike to get the median to move forward to 1 hike that year. This is a bit harder to envision.
3. Tweak its forward guidance – UNLIKELY NOW, LIKELY LATER IN 2021. The new forward guidance introduced at last September’s meeting should remain intact. We do not think the Fed will shift its guidance now. There are simply too many uncertainties with regards to the labor market to changes its messaging yet. As it is, market pricing for the first Fed hike has been pushed out. Earlier this year, the timetable was creeping into Q3 2022 but that has since reversed. Now, Fed Funds futures are pricing in Q1 2023 as very likely and Q2 2023 as fully priced in. By end-2023, two hikes are fully priced in. Right now, we see no need for the Fed to adjust its messaging or forward guidance when the market is moving closer to its view.
4. Taper asset purchases – UNLIKELY NOW, LIKELY LATER IN 2021 OR EARLY 2022. With the pandemic receding and the economy growing well above trend, emergency measures are getting harder and harder to justify. Some have already been wound down but open-ended QE at the current aggressive pace of $120 bln per month stands out like a sore thumb. Please see our Fed Road Map to Normalization. Using the 2013 tapering process as a guide, the minutes show that the Fed has already taken the first steps by beginning informal discussions at the April meeting. The next step will likely be a formal acknowledgment that tapering talks are progressing, either in an FOMC decision statement or in an official statement by Chair Powell. Key dates to watch for ahead are FOMC meetings July 27-28 and September 21-22, along with the Jackson Hole Symposium August 26-28. Current consensus sees tapering in Q4 2021.
5. Jawbone yields lower – UNLIKELY NOW, POSSIBLE LATER IN 2021 OR EARLY 2022. During the Q1 curve steepening, Fed officials validated rising yields as a sign of the strong US recovery. However, officials have remained silent as that trend reversed in Q2. The Fed should take confront in seeing implied inflation rates validating its Average Inflation Targeting (AIT) framework, but the balance, as always, 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 renewed anxiety for markets. If there is any sort of taper tantrum like we saw in 2013, Fed officials would likely make strong efforts to prevent a large spike.
At the margin, rising U.S. yields and less dovish Fed messaging should help boost the dollar, but we stress that it’s about growth as well as yield differentials that ultimately matter for currencies. The ECB, BOJ, and SNB are unlikely to follow the Fed in removing stimulus until much, much later. We saw a similar dynamic play out during the financial crisis and we see no reason for that to change. On the other hand, the BOE and BOC have already tapered while the Norges Bank and RBNZ have signaled their intent to hike rates before the Fed does. As such, we could see a much more nuanced performance for the dollar going forward. Please see our Major Central Bank Roadmap.
The dollar tends to weaken on recent FOMC decision days. In 2020, DXY weakened on nine of ten decision days. In 2021, DXY has weakened on two of the three decision days so far. If the Fed decision causes the market to reprice the long end of the U.S. curve, then we would expect rates to spike higher and give the dollar further fuel to rise.
The dollar is still in the process of carving out a bottom. We thought that process was completed in Q1 but the Q2 drop in U.S. yields led to another move below 90 for DXY this past month. It has since recovered, with DXY trading back near the June 4 high around 90.627. A break above that would set up a test of the May 13 high near 90.907 and then the May 5 high near 91.436. The euro is trading heavy in the wake of the dovish ECB decision last week just above $1.21 and a clean break below would set up a test of the May 13 low near $1.2050 and then the May 5 low near $1.1985. Sterling is trading just above $1.41 and appears on track to test the May 13 low near $1.40. After that is the May 3 low near $1.38. USD/JPY is starting to creep higher towards 110 after being stuck around 109.50 all last week. A break above the June 4 high near 110.35 would set up a test of the March 31 high near 111.