While bond investors expect the U.S. Federal Reserve to keep rates unchanged at its policy announcement on Wednesday, the market reaction could hinge on what Fed officials indicate about stubborn inflation and if their signals get more hawkish about the timing and extent of any easing this year.
Stronger-than-expected economic growth and stickier inflation this year has led investors to push back expectations on the U.S. central bank’s first rate cut to June, from May, and reduce bets on how many cuts are likely this year.
Traders are now pricing in three 25 basis points cuts, in line with Fed policy makers’ median expectations made in December. The Fed is due to give updated economic projections and refresh its “dot plot” graphing policy makers’ interest-rate projections at the meeting.
“What will be really interesting to see is if the Fed is still comfortable in the dot plots to still be showing the possibility of three rate cuts for this year,” said Matt Eagan, head of the full direction team at Loomis, Sayles & Co. “Or will they start to say we’ve got to push back against this a little bit longer.”
Benchmark 10-year Treasury yields rose to a near one-month high of 4.328 per cent on Monday and have jumped from 4.052 per cent a week ago as traders adjust for the possibility of a more hawkish Fed.
The Fed pivoted to a more dovish outlook in December on growing confidence that inflation was on track to its 2-per-cent annual target.
Inflation has since picked up, though analysts note that recent hotter-than-expected consumer and producer price index reports likely reflected seasonal factors.
President Jerome Powell said after the Fed’s January meeting that the central bank wants more confidence that inflation will continue to decline before cutting rates.
“The Fed doesn’t want to break anything,” said Padhraic Garvey, regional head of research, Americas at ING, adding that when inflation gets closer to 2 per cent the Fed will likely “use that opportunity as one to get rates off the highs.”
In the meantime, the Fed may caution about the prospect of near-term rate cuts.
“The main focus is which way they lean,” said Stephen Gola, head of U.S. Treasuries Sales & Trading at StoneX Group.
An unexpected uptick in unemployment last month could keep the Fed circumspect on growth, offsetting some of the inflation concerns.
Another possibility is that Mr. Powell could adopt a more hawkish tone by referencing loose financial conditions as stock markets hit records and corporate credit draws enthusiastic demand.
“He didn’t say it [in January] but stocks have only gone higher and I think they’re going to struggle to achieve what they want to achieve as long as that’s the case,” Mr. Gola said.
Mr. Powell in November cited financial conditions when higher Treasury bond yields, mortgage rates and other financing costs were having a tightening impact on the economy. His comments were interpreted as potentially leading the Fed to hike rates less than expected.
HOW MUCH MORE QT?
The Fed may also signal that it is getting closer to tapering its quantitative tightening (QT) program, in which it allows bonds to roll off its balance sheet without replacement.
QT is meant to remove excess liquidity created by record bond purchases designed to stimulate the economy during COVID-related business shutdowns. So far QT has helped shrink the Fed’s balance sheet to US$7.5-trillion from a peak of around US$9-trillion.
With ample liquidity remaining in the market, Mr. Garvey said there is no urgency to address the issue.
“In our calculations we’ve still got about US$1-trillion worth of excess liquidity in the system,” Mr. Garvey said. “If I saw the Fed getting concerned about taking liquidity away too fast it would lead me to get a bit concerned that they’ve seen something that we’re not seeing in the system.”
The Fed may also expand on Fed governor Christopher Waller’s comments that it may look to shift its mix of purchases to hold more shorter-dated Treasuries instead of mortgage-backed debt.
“Longer maturities have a bigger effect on the market,” Mr. Eagan said. By reducing duration but still buying Treasuries, they can potentially decrease the market impact “without upsetting the plumbing of the liquidity within the banking system,” he said.
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