Three of the four G5 central banks meet in the week ahead: the Federal Reserve, the Bank of England and the Bank of Japan. Only the Fed is expected to change policy, and investors are as sure as they can be that a 25 bp hike will be delivered.
Our calculations, based on assumptions where Fed funds will effectively trade (weighted average) for the second half of the month and where it may trade on the last day of the month (quarter end), suggested that fair value on a 25 bp hike would have the June contract imply a yield of 1.04%. Before the weekend it closed at 1.0325%. Bloomberg, which recently changed its methodology, suggests the market has discounted a 97.8% chance of a hike, while the CME is even higher at 99.6%.
Ironically, the third hike since the US election last November is so greatly assumed, that it is not the most important element of the FOMC meeting, though if it is not delivered, that would indeed overshadow everything else. The simple, even if unpleasant, truth is that the economy’s rebound from the typical Q1 weakness is disappointing, and more, to the point, the preferred core PCE deflator has drifted lower for three consecutive months. The Atlanta Fed’s GDP tracker for Q2 has fallen from a little more than 4.0% to 3.0%. It has converged with the median in Bloomberg’s survey, but the risk is that it is too high still. Our own thinking is more in line with the NY Fed’s tracker that puts it at 2.25%. The NY Fed’s model is not optimistic about Q3, for which it puts GDP at 1.8%.
The most important part of the outcome of the FOMC meeting is what it reveals about how officials see these challenges. The market is not convinced that there will be another rate hike this year (Bloomberg and CME calculations show about a 42% chance that Fed funds target will be at 1.25%-1.50% before the end of the year). Some officials, like Governor Brainard, have already expressed some concerns. Are those shared? What about the reduced expectations for fiscal support this year? The economic projections (dot plot) may take on heightened significance.
There has been much discussion that financial conditions eased in the face of the Fed’s gradual effort to remove accommodation. There are several different measures, but they agree that financial conditions, which take into account various interest rates, equity prices and exchange rates, are at two or three-year lows. This is a powerful argument in favor of additional Fed efforts. It judges that level of monetary accommodation that the economy needs. It judges it needs less, but for various, and admittedly not always well understood, complex factors, conditions are more accommodative.
This need not be a question of whether monetary policy is market-dependent or data-dependent. The confusion may lay with the popular claim that the Fed has a dual mandate. In truth, it has three. In addition to full-employment and price stability, is financial stability. The tightening of financial conditions in Q3 15 deterred the Fed from hiking in September, as it had encouraged investors to anticipate (and strategists:-( ).
Investors also will focus on indications about the coming new balance sheet regime, where the Fed will not simply roll over all maturing issues. In effect, it will unwind the swap that has been dubbed QE. The Fed swapped reserves for Treasury bonds and mortgage-backed securities. Officials want to make the process as least disruptive as possible.
