This week, the FOMC will hike 25bp and a few more Fed officials should signal their comfort with four rates hikes for this year in the dot plot. The Fed is expected to note that risks should remain balanced, with Chair Powell potentially de-emphasizing some of the downside risks - and certainly the mounting trade war tensions - that have preoccupied markets of late.
Notably, the Fed's Summary of Economic Projections (SEP) will for the first time contain 2021 economic and policy projections for the first time (although it is unlikely that the Fed will indicate a recession is coming). According to TD, while the 2021 economic forecasts may be closer to their longer-run values, the 2021 dots need not be, as it may take a period of mildly restrictive policy to push the economy back to its long-run equilibrium.
That said, projections that suggest Fed officials have become more cautious about the future, perhaps due to a belief that fiscal stimulus is more front-loaded than previously thought, or downside risks have become more salient, would be dovish. While some market commentary suggests this may occur, recent Fed speeches do not suggest such a shift is likely
Also of note, there will be a change in the FOMC participants, namely the addition of Vice Chair Clarida, the replacement of New York Fed President Dudley with the projections from the First Vice President at the San Francisco Fed (as Williams moved from SF to NY), which could add some volatility to the projections at this meeting, although TD Securities does not expect any of these changes to deviate too sharply from the consensus on the FOMC.
As always the market will be most focused on the dot plot. Importantly, economic forecasts barely change between end-2018 and end-2020 in the June SEP, yet the median number of hikes is four during this two-year period. That, to TD's Priya Misra, "reflects the widespread belief on the Committee that policy needs to return to neutral, and even potentially move somewhat higher as growth remains above potential, unemployment below NAIRU, and inflation above target in 2020." However, contrary to the prevailing dovish take post Jackson Hole, TD expects most of the 2019 and 2020 dots to suggest a tendency toward modestly outright restrictive policy relative to the longer-run dots.
In fact, a sizable majority supports hiking beyond neutral, even though the median longer-run dot could drift down to 2.75% thanks to newly added participants. This then raises the odds that the statement language is modified to suggest "policy remains somewhat accommodative."
Some additional observations from Misra:
- The net addition of one new participant in September (add Clarida and SF Fed stand-in, lose Dudley) means the longer-run dot will move: right now the median dot is between 2.75 and 3%, as only 14 were submitted in June. (Bullard has refrained from submitting a longer-run dot for a while.) There is a slightly better-than-even chance that the median will settle at 2.75% in September, although it is a very close call. Over time, the median longer-run dot will settle at 3%. The outcomes here are fairly bimodal: dipping back down to 2.75% will be seen as modestly dovish for a market that has struggled to price the Fed hiking to its median longer-run dot; rising back to 3% would likely be seen as somewhat hawkish.
- A reading of the collection of speeches heading into the September meeting suggests that one or two 2018 dots could shift up from three hikes for this year to four. That reinforcement of the June median should primarily serve to reinforce the recent move higher in market pricing for the December meeting.
- For 2019 it would only take one dot at the median to move lower to shift the median down to two hikes for 2019 from three currently. (At least four dots at the June median would have to rise to shift the median to four hikes for 2019.) TD does not see a "strong case for the median dot in 2019 to change, but there is some chance it could drift lower — and markets would take a dovish view of that shift."
- For 2020, there is also no compelling case for any change to the median dot: it would take two moving up to get a higher median, and three moving down to get a lower median. The 2020 dots will continue to show a sizable majority of Fed officials expect it will be appropriate to hike somewhat above neutral during this hiking cycle.
- The outlook for the 2021 dots is less certain, and may not be all that market relevant given how far they are into the future. That said, our base case is for a similar median as the 2020 dots (perhaps with a tighter range or central tendency). If some number of Fed officials think it will be necessary to tighten further to cool an overheating economy, the 2021 median dot would be higher than the 2020 one; if some number think that earlier hikes already achieved that objective and policy itself needs to revert to neutral, the 2021 median dot would be lower than the 2020 one. TD notes that the former is slightly more likely than the latter given the size of the gap between the unemployment rate and NAIRU in 2020 and the expectation that it will not close quickly in 2021.
Finally, here are the rates market implications per Misra:
The September hike is fully priced and the rates market is pricing in more than 80% odds of a December hike and about 2 hikes next year. The market is pricing in a Fed terminal rate of 2.85% and Fed pricing has moved significantly higher in recent days. Not only did the market take December hike odds from 65% in late August to 82% currently, but the market has increased the pricing for 2019 hikes from 1.5 to almost 2 hikes.
Given recent price action, our base case scenario for the Fed should result in a modest bullish reaction for Treasuries. As discussed above, we think that the trifecta of Fed communication at this meeting should reinforce a gradual hiking stance, but much of that is already priced in. Historically the market has been impacted more by the near-term dots than the long run dots. While some dots will likely move from 3 hikes in 2018 to 4 hikes, we think that this is already penciled into the 80% odds of a December hike. A shift lower in the long run dot (even though it may well be driven by just one dot) should be viewed dovishly. This should also help the curve bull steepen slightly on a tactical basis.
Note that the market is not pricing in hikes beyond neutral, which could make it vulnerable to a bear flattener if the Fed stresses an overshoot of the neutral rate. While 2021 dots will be new, the market has historically not been impacted by dots that far out. Further, the Fed has been careful about emphasizing too much on their estimate of r* itself. In fact, Chair Powell stressed the uncertainty around r* (as well as u* and y*) in his Jackson Hole address. We think that the Fed wants to downplay forward guidance that far out into the future. Thus even if the dot plot suggests an overshoot of neutral, we don't think that it will be enough to move market pricing above r*.
Thus we remain long US rates, both outright via receiving long 5y5y swaps and against Europe (receiving in 10y US swaps versus paying in 10y Euro swaps). We also hold on to our 5s30s Treasury flattener even though we acknowledge the bull steepening risk from the Fed next week. But on a strategic basis, additional hikes should continue to exert upward pressure on the front end while the long end should stay more anchored due to global rates, low r* and structural pension demand for the long end.