Fed: March Positioning

Published on February 13, 2017
SGH Insight
While we do not expect Federal Reserve Chair Janet Yellen to send an overt signal about March in her twin testimonies on Capitol Hill tomorrow and Wednesday, we do think she will affirm the Fed’s confidence in the near term outlook and the high likelihood for a gradual pace of continued rate hikes.

And if that is taken by the market to be relatively hawkish, from the Fed’s perspective, that may not be a bad thing.

*** We still think a March rate hike is more unlikely than not, but there does seem to be an undercurrent of sentiment within the FOMC strongly leaning to a more tactical positioning for a March rate hike or at minimum, to open the door more explicitly to a rate move in May. In that sense, the “every meeting is live” mantra of the previous years is finally more real than rhetoric. ***
Market Validation
(Bloomberg 2/14/17)
USTs Fall, Eurodollars Steepen, as Yellen Raises March Odds 10:12
Treasuries sharply lower in response to Yellen text which says “waiting too long to remove accommodation would be unwise,” and that further adjustment would likely be needed if economy is on track.
• 5s30s aggressively flattens in response, reaches 109.5bp, flattest since Jan. 20 and 1.7bp flatter on the day
• 10Y futures sell off around 12 ticks, reach 124-03, matching Feb. 3 lows
• Eurodollar strip bear steepens with whites lower by 1bp-3bp and greens, blues lower by 6bp
Fed fund futures based on April 2017 contract show about 34% chance of a rate hike at the March FOMC meeting vs 30% pre-testimony

While we do not expect Federal Reserve Chair Janet Yellen to send an overt signal about March in her twin testimonies on Capitol Hill tomorrow and Wednesday, we do think she will affirm the Fed’s confidence in the near term outlook and the high likelihood for a gradual pace of continued rate hikes.

And if that is taken by the market to be relatively hawkish, from the Fed’s perspective, that may not be a bad thing.

*** We still think a March rate hike is more unlikely than not, but there does seem to be an undercurrent of sentiment within the FOMC strongly leaning to a more tactical positioning for a March rate hike or at minimum, to open the door more explicitly to a rate move in May. In that sense, the “every meeting is live” mantra of the previous years is finally more real than rhetoric. ***

*** Indeed, the burden of proof seems to be shifting within the Committee onto those members arguing against near rate moves in contrast to the almost opposite balance last year. As a consequence, we are moving up our odds on a March rate hike to 30% or higher, compared to what we previously thought was more like a 15% – 20% probability. ***

A Shifting Committee Sentiment

While it is hardly a majority Committee consensus, our sense in recent weeks is of a gathering sentiment within the FOMC for a more tactical, modestly more hawkish policy positioning in the run up to the March meeting. The recent remarks by several Committee members that every meeting is live or that March is not off the table is not necessarily coordinated, and it certainly does not reflect a majority view.

But even though this every meeting is live view may not necessarily coalesce into a high probability for a March rate — and it obviously assumes the upcoming data will be supportive — the argument nevertheless seems to be  gaining momentum. And it is not so much a hard case for a March rate move as it is about nudging the balance within the Committee consensus and how it should position the market expectations in the communications into March and the spring.

And we do have a sense that the burden of proof within the Committee is indeed shifting onto the shoulders of those arguing against near term rate hikes. In the last two years, caution and prudence was the hallmark of the approach to rate moves. Last summer, for instance, when the Committee felt less confident on the economic momentum, the risk management considerations over Brexit risk or a persistently low neutral rate was enough to tip the scales against an intended rate move.

But the Fed these days are feeling that much more confident about the economic outlook and attaining its twin mandates (“inflation will rise to 2%” as emphatically asserted in the the January statement). A March — or May — rate move would put the Fed and the level of accommodation in a better position for the second half of the year, providing more flexibility on the timing to a second, and possible third rate move before year end.

And while there is yet again a cloud of European political risk on the horizon with the May French elections, this time perhaps the Fed should get in front of it rather than wait to gauge the fallout. The risk, after all, so this thinking goes, is to the upside in light of the expectations for a Trump fiscal stimulus.

Base Case Rate Outlook

That said, we still think the Fed’s most likely base case rate path this year remains for a next rate hike at the June meeting. Under the scenario, a June rate move would be followed by at least one more hike before year-end, with decent odds on a third move this year as insurance against any indications for an acceleration of price pressures in 2018.

A clear FOMC majority still sees no particular urgency for a rate move so soon after December’s move. Growth should continue just above trend, but is unlikely to “markedly” pick up in the near term, as Chair Yellen noted in her Stanford speech. The labor market should continue to tighten, but slack remains on its outer edges, and wages are likely to be only gradually picking up through the year.

More to the point, there are no indications of the expected slow upward trend in the core inflation measures picking up at some sort of threatening, accelerating pace. The Fed is not falling behind that proverbial curve, as Chair Yellen also asserted in January.

There remains, as well, an uncertainty over the level of the estimated equilibrium interest rate, which, coupled to the inertial inflation, argues for the Fed’s reactive rather than pre-emptive policy posture, at least through the first half of this year, or until there is clarity in particular on the “size, timing, and composition” of the Trump Administration’s mix of fiscal, tax, and regulatory policies (see SGH 1/19/17, “Fed: On the Near Policy Path”).

Perhaps the most important aspect of that base case scenario is how much it is driven by the current policy normalization strategy as the economy nears maximum employment and a mandate-consistent inflation. “A few rate hikes” are coming this year, and they are being penciled in for most part with perhaps less than half the Fed system staff only marginally penciling in some degree of fiscal expansion, beginning in 2018.

But even under that scenario, in other words, the rate risk is to the upside.

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