FOMC Preview: "Steady As She Goes" Or "Quasi Carney"
Goldman Sachs, like most of the mainstream economists believes today's FOMC statement will likely be "broadly neutral" with no indication of sooner rate rises than expected (despite what we have noted as the timing not being better), some modest upgrades to the economic outlook (to keep the "everything's good and you don't need us anymore" meme alive), and continued taper at the same pace (with maybe some acknowledgemnet of the transitory pop in inflation). UBS, on the other side, suggests there is a chance of some FOMC surprises with Janet Yellen pulling a semi-Carney as Citi's Steven Englander has previously noted "the Fed needs more volatility in order to maintain its illusion of omnipotence."
What Goldman Thinks..."steady as she goes"
The economic data have, on balance, been encouraging since the April FOMC meeting. Although Q1 GDP was unexpectedly weak, the high frequency indicators point to above-trend growth. Inflation measures have, on net, firmed a bit and financial conditions have eased to their most accommodative level since early 2008.
A further modest tapering step seems to be a foregone conclusion in light of these developments. The FOMC is widely expected to continue tapering the pace of its asset purchases by a further $10bn to $35bn per month, with the reduction split equally between Treasuries and mortgage-backed securities.
The committee is likely to make some upgrades to its description of the economic outlook in the post-meeting statement and its economic projections. Although the committee will need to reduce its 2014 real GDP growth forecast to take into account the Q1 disappointment, we would expect the committee to reduce its unemployment rate forecast and lift its inflation forecast slightly.
These upgrades would, by themselves, suggest that the funds rate projections (or “dots”) might drift up and that the press conference might accordingly tilt towards the hawkish end. Three considerations, however, would point to a more neutral message: (1) the change in the FOMC’s composition, on balance, probably entails a dovish shift; (2) the committee’s projections of the longer-term funds rate might come down a bit; and (3) at the margin Chair Yellen might have become more comfortable in steering the monetary policy message in the direction of her own views at the post-meeting press conference.
Taken together, we therefore expect a broadly neutral message. Our financial conditions rule would suggest that such an outcome would be desirable, as highly accommodative financial conditions remain appropriate to support the ongoing recovery.
And BofA is consensus...
FOMC Rate Decision
We do not expect any significant policy changes at the June FOMC meeting: the Fed is likely to taper by another $10bn (bringing the purchase pace down to $35bn per month: $15bn in agency MBS and $20bn in Treasuries) and maintain its current forward guidance language. Data since the April meeting have been mixed: our tracking model now pegs 1Q GDP growth at a dismal -1.9%, but more timely monthly indicators confirm a strong 2Q pick-up. The central tendency growth forecasts for end-2014 currently are far too optimistic, in our opinion, and we look for them to be revised down toward 2%. Conversely, the unemployment rate appears to be falling slightly faster than the FOMC has been anticipating, so that projection could be reduced by a few tenths, as well. These potentially offsetting forecast revisions may increase the dispersion of the dot plot. Several new voters on the FOMC will add some uncertainty to the economic and policy forecast changes.
Yellen’s press conference likely will suggest a slowly improving outlook and once again downplay shifts of the dots. We expect her to emphasize that the labor market will still take time to fully recover, and that inflation is gradually reverting to target from below. Thus, she should continue to reiterate the majority-supported case for a patient policy stance and a gradual tightening cycle. Any discussion of the exit strategy sequencing, tools or end game also will get a lot of attention. As in March, the risk is that an off-the-cuff comment or small shift in the dot plot will be magnified by the markets. Focus on the FOMC statement language and Yellen’s prepared remarks to avoid any “Fed fakes.”
But there is room for Surprises (as UBS Notes)...
Maybe Janet Yellen and friends will pull a semi-Carney
We doubt that the Fed will do anything nearly as dramatic as Mr. Carney's speech at Mansion House. Still, we think there is a decent chance that the Fed deviates from the uninteresting consensus. As our economists have noted, the FOMC's roster is changing significantly, and that should generate some shifts in the famous "dots." In our opinion, US rates investors should be prepared for several other potential surprises:
Boost the long run policy rate. Likely reaction: modest 2s/10s bear steepener
We look for a muted move in this scenario, because it does not translate directly into earlier rate hikes but implies a higher 5y5y rate. Our US economists expect the Fed to reinforce the view that long-term normal Funds rate is around 4%. Some investors and pundits have argued that the policy rate will top out in the 2-3% range. They point to the combination of relatively slow economic recovery, still-low inflation, the perception of bubble-like valuation in risk assets and danger to the US housing market. We doubt the Fed will be swayed. We are more impressed by our economists' argument that the enormous size of the Fed's balance sheet should call for more, not less, tightening.
Increase inflation expectations. Likely reaction: 3-5yr underperformance
In particular, we think this scenario would lead to 2s/5s bear steepening and 5s/30s bear flattening. UBS calls for US inflation to rise, based largely on the view that the US labor market has less slack than headline figures indicate. Our recent conversations with investors suggest that this stance is starting to win converts. The FOMC has yet to be converted. Moving to less sanguine language on inflation could jolt the market.
Accelerate tapering. Likely reaction: bear flattener
Tapering seems to be on autopilot. The current pace of $10 billion in tapering announced at each FOMC meeting implies that the Fed's balance sheet expansion will end in November. Nonetheless, the Fed could change its pace. For instance, it might announce that the eventual final tapering move will be a decrease in combined monthly purchases from $15 billion, or even $25 billion, to zero. Either way, the timeline for the first increase in the funds rate would accelerate. Making the last move from $15 billion to zero would end tapering in October and probably result in a modest bear flattener. Making the last move from $25 billion to zero would end tapering in August and we think would trigger a big bear flattener. Maybe a grizzly bear.
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