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Fed’s dovishness may depend on end of QT and inflation targeting

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The dovish pivot delivered by the Fed may have killed volatility with currencies and bonds, but the conclusion of the two-day meeting could see markets scale back expectations for the Fed’s next move to be a rate cut.  The conclusion of the FOMC meeting is expected to see interest rates kept steady, while the possibility of a rate hike at the end of the year may not be ruled out.

The dot plots and projections will also be released and provide further clarity on their take with the US economy.  The Fed may also end or provide guidance on quantitative tightening.  With the market overly pricing in a dovish meeting, the risks remain high that we could have some hawkish surprises.

  • Fed to lower Dot plots and projections
  • Markets are heavily pricing in a Dovish outcome
  • Will the Fed end the Balance-sheet runoff?

Dovishness

The Fed is likely to be overly cautious going forward on the potential signaling of further tightening.  Most economists still see one more rate hike this year, while the financial markets are pricing in the next move to be a rate cut.  Fed Chair Powell is likely to emphasize a cautious tone and maintain a data-dependant approach that will allow them to slightly overshoot their inflation target.

Dot Plot Expectations

The Fed is expected to downgrade their 2019 rate hike forecast from two hikes down to one.  If the Fed does deliver a message that they still think they could hike once in 2019 and once more in 2020, we could see markets view the Fed as not being sensitive enough to the growing headwinds: Trade deal uncertainty, dashed hopes for an infrastructure deal, slower global growth, and liquidity concerns once QT is ended.

Balance Sheet

The Fed began shrinking its balance with Janet Yellen back in October of 2017.  It has been lowered from around $4.51 trillion to $3.9 trillion.  The current tightening schedule has been removing $50 billion of Treasury and mortgage-backed securities holdings on a monthly basis.

The Fed has signaled they are preparing the end of their quantitative tightening program (QT) and they could announce final plans at this meeting or the May 1st one.  The Fed may provide further clarity on the new facility that will control the Fed Funds rate, once QT is over with.  The tighter liquidity conditions will need to be addressed as bank reserve balances come down once they fall off the balance sheet.  The Fed will still need to inject money into markets and they will provide clarity soon on how they will do that and what type of Treasuries they will hold, short-term bills or a combination that would also include longer-term bonds.  Banks will still need to hold on to US debt to comply with post-financial crisis regulations and that will likely keep demand high for Treasuries and possibly drive rates higher.

Inflation Targeting

The Fed may also adopt inflation targeting, which would allow them to overshoot inflation.  If they commit or signal they are strongly considering inflation targeting, stocks and high-beta currencies could see a bid as a tightening bias would require a sustained move above their inflation target.  Currently inflationary pressures are not a threat and if they adopt inflation targeting, we probably not see risks for tightening until core PCE rose towards the 2.4% area.

What could we expect?

A dovish hold is expected along with a downgrade in both the projections and dot plots forecast. Signaling the end of QT and abandoning the 2% inflation target and adopting a more targeted approach could add to dovish expectations.  Risks to the economy still remain, as uncertainty brews with the US/China trade war, global growth concerns persist and inflation remains muted; that is probably why rate hikes are off the board throughout the summer.  Once those headwinds become tailwinds, we could see the tightening bias return.

Reality check on trade deal

All is not done with the trade war.  Earlier in the month, overly optimistic hopes were dashed for a mid-March meeting in Mar-a-Lago and now it appears the next step is for Us Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin to go to Beijing the week of March 25th.  Stocks erased most of their gains after some US officials reportedly displayed some skepticism in talks and noted they could see China walking back trade offers.

A trade deal is still likely, but not a foregone conclusion.  The risks of further hiccups are growing and nothing will be finalized until we see a meeting between President Trump and Xi.

Oil fizzles after US concerned China may rescind some concessions

The OPEC + production cuts may have run their course.  The crowded bullish trade for oil is approaching major technical levels (WTI at $60/barrel and Brent at $70/barrel) and we could see market participants grow nervous on how much higher this rally has left in it.  Crude prices saw weakness after reports that trade negotiations between the US and China may have hit a roadblock.  China is a key part of the story for oil demand and the longer it takes to finalize a deal, the worse off the demand side argument is for higher prices.

The supply side case for higher prices will face difficulty as OPEC+ production cuts may see resistance from Russia.  Russia is happy with where oil prices are, and they may want to start normalizing their output sooner, rather than wait till next year.

US production is expected to remain strong during the warmer months and the tug of war with Saudi Arabia will continue as they over deliver on their production cuts and reduction of exports.  

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