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FOMC Preview: Hawkish On Inflation, Dovish On Risks

Courtesy of ZeroHedge. View original post here.

The Fed is expected to leave rates on hold today (two-thirds chance of no rate change)…

However, the key is whether they nod to recent economic weakening or stick to a positive message.

Wall Street will be looking for any nod to firmer inflation for potential hints of more rapid rate rises. If the FOMC statement cites the price pickup and continued moderate economic growth, it is likely to reinforce expectations of a rate hike in June. Investors anticipate two or three more moves this year.

“How they choose to alter the characterization of inflation is important,” said Stephen Stanley, chief economist at Amherst Pierpont Securities. “They have been saying for a long time it’s running below target. There are shades of gray” in their portrayal.

Bloomberg economists – Carl Riccadonna and Niraj Shah – expect the official communique from the May FOMC meeting, Jerome Powell’s second as Fed Chairman, will incorporate only minor changes to the assessment of economic conditions. Most notable will be the characterization of recent inflation news — sustained 2 percent inflation finally appears to be within reach. There is little need for officials to more clearly communicate a June rate increase, as it is already priced into the fed funds futures market with a likelihood of over 90 percent.

We do note that there is an interesting relationship beginning to take hold between The Fed's normalization of its balance sheet and the rise in longer-end yields…

A $100 billion reduction in the balance sheet has coincided with a 100bps rise in 10Y rates. Will they stay on this tack?

“I just expect a ‘stay the course’ statement with just a few changes aimed mostly at marking to market the outlook,” said Roberto Perli, partner at Cornerstone Macro LLC in Washington. “The June meeting should be more interesting. This week will probably just be about buying time.”

But what's priced in? Rafiki Capital Management's Steven Englander explains, the bottom line: a hawkish turn on inflation language is already priced in, and the FOMC probably does not want to lock in on four hikes this early in the year.

The FOMC will sound hawkish on baseline and dovish on risks. The hawkish baseline is that the language on inflation needs a makeover. The dovish part is that there is likely to be some explicit reference to downside risks – otherwise there is nothing to balance the inflation language change.

With trepidation, I am going to make the case that the market already prices in hawkish Fed language and intentions as a baseline.

Unless the Fed signals ‘Inflation Code Red’ (unlikely at a no-presser and in the absence of preparation), there is likely to be enough risk language to convey that there are reasonable circumstances when they would not hike. Hence, I see upside for equities and downside for USD on FOMC event risk.

Their baseline bogey is that the inflation language in the last Statement is way out of date (my bold):

On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent. Market-based measures of inflation compensation have increased in recent months but remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”

At their last meeting, the last reads on core and headline PCE were 1.5% and 1.7% respectively. Now they are 1.9% and 2.0%, so honesty now forces them to say something like “inflation is now running close to target”.  

They will have a hard time repeating that “Inflation on a 12-month basis is expected to move up in coming months and to stabilize around the Committee's 2 percent objective over the medium term” because there is scarce room to move up without going beyond 2%.

Maybe they can say something like “both headline and core inflation are now approaching 2%”, and “Inflation on a 12-month basis is expected to stabilize around the Committee’s 2% objective”. Normally, you would view this as a hawkish shift, but much of this is already priced in and would not convey too much concern.

From a market perspective, start from the view that no one see five or more hikes this year. In March there was only one dot for more than four hikes. This is very important because it means that only 15bps is left to be priced in till you get to the full four hikes. (I think investors are underpricing the risk of five hikes, but my view doesn’t change market pricing.)

Another 5bps added to end 2018 fed funds would price in a 60 percent chance of four hikes – with seven months and all downside political, economic and market risk compressed into a very limited amount of risk. Investors now price almost certainty that the FOMC will hike in June and September. The FOMC doesn’t have to say that they won’t hike – all they have to say is that there are risks on top of a generally positive picture.

From that perspective I think it is hard for 2018 fed funds to react much to the likely inflation rhetoric. Take it as a given that a no-Press Conference meeting is not where the Fed will open the door to the possibility of more than four hikes in 2018. (We may see some Fed speakers alluding to the possibility in coming weeks but I have a 24 hour time horizon now). They need to find some downside risks somewhere and they are likely to raise downside risks in some oblique fashion to balance the call to action that recent inflation numbers are signaling.

(As a bonus comment, Englander notes that he also expects AHE to come in on the soft side this month, largely for technical reasons, so if I am right on both FOMC and AHE views, equities look good, less so USD, and bond yields will come off as much as an equity rally permits.)

*  *  *

Here is Goldman Sachs' best guess at what the FOMC Statement will look like…

And here is Morgan Stanley's view of the statement…

And finally, MS on how to trade it, or rather not:

Nothing to do

From a medium-term perspective, we don't think the FOMC statement will stand in the way of further flattening. As our economist's expectations for the FOMC statement suggest, it is likely to ring just as hawkish as the March statement, but no more so. This outcome may not be as hawkish as market participants are feeling themselves. Both headline and core PCE inflation will be much closer to 2 percent, on our economist's forecast, so investors will be looking for some acknowledgment in the statement.

Investors will also look to see whether the FOMC statement describes monetary policy as remaining accommodative. Continued references to policy remaining accommodative would suggest the Committee still has further to go in raising rates. While "some" participants discussed changing this characterization "at some point" during the March meeting (see quote from the FOMC minutes below), we think the risks skew to the Committee continuing to describe policy as accommodative, given inflation is higher than expected at this point in the year (meaning real policy rates are lower than projected).

Market pricing of the path for rates remains below the average FOMC participant path (see Exhibit 4), but that masks the dramatic revision to the expected path since the beginning of the year (see Exhibit 5).

As a result of the dramatic repricing of policy expectations since the start of the year, lack of a further, hawkish shift from the FOMC will make it more challenging for the short maturity bonds to underperform. As a result, we think the yield curve may have more difficulty flattening than it has in the past – at least until the June FOMC meeting when the FOMC will have another chance to opine on policy.

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