fra BNP Paribas:
US FOMC: More hawkish than expected
The FOMC statement came close to expectations, but the Survey of Economic Projections
(SEP) had a more hawkish message than the market had expected.
Despite uncertainties about earlier downward inflation surprises and a likely muddied picture
because of hurricanes, most FOMC members felt a December hike is likely appropriate.
Our confidence in our call for no hike in December is diminished, but a lot of data will flow
under the bridge before the December meeting. The Fed may be keeping options open.
Key things to watch are inflation, inflation expectations and labour market figures. The
picture will be messy in October data, so clarity may come only later.
The FOMC initiated its well-telegraphed balance sheet adjustment in line with its “Policy
Normalization Principles and Plans,” which was introduced at its June meeting. The shift came
as no surprise. The Survey of Economic Prospects (SEP) showed the median expectation of
FOMC members is for one more rate hike in 2017 and three in 2018, unchanged from the June
meeting. Overall, the Committee’s economic forecasts changed very little, with a mildly lower
unemployment rate in 2018 and core PCE inflation marked-to-market for 2017 – supporting
what many on the FOMC have described as transitory price effects. The terminal fed funds rate
was lowered.
Now, with the balance sheet adjustment underway, the Fed will assess the impact of the shift
and closely monitor inflation developments in the coming months before deciding on the next
move. In our view, data are likely to be disrupted by the hurricanes, and the uncertainties
surrounding the inflation outlook are unlikely to be resolved before the December meeting.
Nevertheless, the Committee is sending a fairly strong signal that they could look through the
data disruptions as the majority continue to expect one more hike this year. We feel nervous
about our forecast for the Fed to remain on hold until March 2018, and will be closely monitoring
incoming data.
While some of the hawkish dots moved down for this year and beyond, none of the centrist dots
moved down this year, which surprised us, especially given the uncertainty that Chair Yellen
seemed to convey about inflation in the press conference. Maybe the Fed is just waiting for
more evidence and wanted to avoid a December hike being priced out if they were dovish.
Balance sheet policy
The balance sheet “normalization” will begin in October with the caps on the maximum rate
of run-off in Treasuries and agencies initially set at USD 6bn and USD 4bn per month,
respectively.
Author:
Paul Mortimer-Lee
@MortimerLeePaul
Chief Market Economist and Head
of US Economics
Bricklin Dwyer
Senior Economist, US, Canada
New York BNP Paribas Securities
Corp
XXX Balance sheet as
expected; SEP surprise
Chart 1: FOMC rate expectations Chart 2: FOMC unemployment forecast too high
Source: Federal Reserve Bank, BNP Paribas Source: Federal Reserve, Macrobond, BNP Paribas
Balance sheet adjustment
to begin in October
6
@MortimerLeePaul 21 September 2017
Macro Matters www.GlobalMarkets.bnpparibas.com
The caps are expected to increase by USD 6bn for Treasuries and USD 4bn in agencies
every three months until they reach a limit of USD 30bn and USD 20bn, respectively.
The caps will remain in place until the Committee thinks the balance sheet is at an
equilibrium level – we see this as about USD 3.0-3.5trn, with some on the FOMC board
suggesting it will take about four years to reach.
Economy
Generally, the adjustments to the language about the economy were positive, with
upgrades to job gains, household spending and business investment.
There was a carve-out in the statement to acknowledge the potential disruptions from
Hurricanes Harvey, Irma and Maria, which were “unlikely to materially alter the course
of the national economy over the medium term.”
The adjustments to the Summary of Economic Projections were modest, with a slight
reduction in the unemployment rate in 2018 and 2019, lower near-term inflation and
slightly better GDP growth in both 2017 and 2019. The median estimate for longer-run
GDP growth, the unemployment rate and inflation were all unchanged.
Inflation
There were few changes to the inflation outlook outside of expected higher prices for
gasoline and some other items in the aftermath of the hurricanes.
The Committee continues to believe inflation “on a 12-month basis is expected to remain
somewhat below 2 percent in the near term but to stabilize around the Committee’s 2
percent objective over the medium term.”
Rates
The dot plot of appropriate interest rates revealed a drop in expected rates from 2019,
including the long-run neutral rate that declined to 2.8% from 3.0%. The Fed – as so often
in the past – still sees the equilibrium short-term real rate as likely to rise over time. But,
they periodically keep revising this down: we doubt we will see 2.8% in
this cycle.
For 2017 and 2018, while the median dot did not fall, the hawks dropped their expectations
a bit, as they did for 2019.
With the difficulty to parse out the trend in data on the back of the hurricane impacts, we
think there is a good case for the FOMC to keep rates on hold for the remainder of the
year. We see no more FOMC members joining the current four who support this as a
holding operation, pending more data. The September statement has left the door for a
December rate hike very open. Like the Fed, we will be monitoring the inflation data in the
coming months.
The risk to our view is that the Fed looks through the data disruptions and, with prices
rising as a result of the hurricane disruptions, they deliver another 25bp rate hike at the
end of the year.
Overall, this was a fascinating FOMC meeting, with the SEP giving a more confident impression
than we had expected of the Fed’s faith in its inflation forecast after a string of downward
surprises, especially since the Chair sounded less than certain about inflation’s trajectory. With
data distortions almost certain to come, due to hurricanes, a clear picture will likely not appear
for some time. The data we will closely monitor are broad, but include inflation and inflation
expectations, and labour market figures. Clarity will most likely be lacking until the November or
December releases.
The Federal Reserve will begin to normalise its balance sheet in
October. This should add USD 730bn of US Treasury and USD 550bn of
mortgage-backed securities supply over the next three years.
As the Fed’s SOMA portfolio declines and the proportion of UST (and
MBS) held by the private sector increases, we expect term premium to
rise from low levels, taking the US rates curve higher and steeper.
(See Fed Balance Sheet Normalisation)
Various studies on US QE suggest the program has reduced the 10y term
premium by 75-100bp. It is likely to be less for the unwind as the ‘normal’
level of the Fed’s balance sheet is now much higher and the pace slower.
Nevertheless, the rise in term premium is not fully priced in because: (i)
global QE matters – the ECB and BoJ are still buying in size; (ii) the carry
trade continues amid low volatility; (iii) the Fed balance sheet reduction is
slow initially; and (iv) inflation data were weak in five of the last six months.
We forecast the US rates sell-off to accelerate in 2018, specifically
from Q2, with a higher rate of roll-off, ECB tapering and US headline
and year-on-year core inflation set to rise.
With the risks of a Fed funds hike in December increasing after a hawkish
tone to the Summary of Economic Projections, we continue to recommend
our structural 5y5y payer swaption to position for higher US rates and
volatility, complimented by our positively-carrying payer/receiver spreads
and our long-term 2s5s forward steepener.
In the eurozone, we look for a pause before a further rise in yields, with the
Bund looking oversold and net EGB supply to turn negative again. We
continue to hold our short 5y OBL, pay forward 2s5s10s EUR swap fly and
10s30s OAT flatteners. In spreads, we recommend taking profit on our
PGB flattener, following the surprise rating upgrade to Portugal from S&P.
