The Fed updated “dot-chart” of all FOMC members’ expectations of the appropriate policy rate points to only an incrementally less dovish stance. Based on a weighted average FOMC members still only expect one 25bp hike by end-2023, according to our estimates.
Fed seems eager to cool market concerns that it will have no choice but to start hiking rates and to ultimately cap Treasury yields or at least slow recent increase in long-end yields. Price action in 2 and 5-year Treasuries suggests it partly succeeded, even if briefly.
However, this still very dovish Fed policy rate outlook jars with its updated forecasts for US inflation and particularly GDP growth. The Fed’s twin arguments are that rapid growth this year will not be very inflationary due to slack in labour market and that following a period of inflation-undershoot it’s willing to accept a modest overshoot in PCE-inflation above 2%.
The latter will have come as little surprise. The more contentious issue in our view is the Fed’s prognosis that core PCE-inflation will rise only modestly from 1.5% yoy in January to 2.2% yoy by end-year despite US GDP growth hitting a 37-year high of 6.5% this year.
The Treasury yield curves have steepened further in the past 72 hours. This suggests that bond markets are not convinced about the Fed’s macro/policy matrix or that the Fed’s pick-up in Treasury purchases in the past couple of months will prove sufficient.
Moreover, the 6.9% collapse in crude oil price yesterday and correction in US equities (particularly the more risk-sensitive Nasdaq) are clear pointers that markets remain concerned about the impact of higher US yields on global demand and equity valuations.
FX markets have been more sanguine. Global FX volatility has risen in past 72 hours but remains in line with 10-year average and most currencies, particularly in Asia, have moved little. The safe-haven Dollar has proven relatively resilient, in line with our February view.
While the Russian Rouble has (perhaps unsurprisingly) weakened most, most other high-yielding emerging market currencies have outperformed, thanks in large part to greater-than-expected central bank rate hikes in Brazil and Turkey of respectively 75bp and 200bp.
The risk now is that markets redouble their attention on central banks perceived as being “behind the curve”. These include the Norges Bank and CE3 central banks in our view.
An almost imperceptible hawkish shift in Fed’s policy rate forward guidance
The Federal Reserve left its policy rate unchanged at 0-0.25% at its meeting on 17th March (no surprises there). More importantly the updated “dot-chart” of all Federal Open Market Committee (FOMC[1]) members’ expectations of the appropriate policy rate points to only an incrementally less dovish policy stance.
- At its 16th December 2020 policy meeting, the weighted-average of all FOMC members’ policy rate expectations implied no rate hikes in 2021, only 1.5bp and 12bp of hikes in 2022 and 2023 respectively and a more material 223bp of hikes thereafter, according to our calculations (see Figure 1).
- The updated “dot chart”, published alongside the Fed’s updated economic projections on 17th March, implies that FOMC members (again using a weighted average) still project that it will be appropriate to keep the Fed funds rate unchanged this year but that 7bp, 21bp and 208bp of rates hikes in respectively 2022, 2023 and beyond will be appropriate.
Put differently on average FOMC members attribute a 28% probability of a single 25bp rate hike next year and an 83% probability of another 25bp hike in 2023. Notably FOMC members’ expectation for cumulative rate hikes in the longer-run (235bp) did not rise compared to its December meeting dot-chart (it actually fell very marginally to 235bp from 236bp) – see Figure 1.
Our simple interpretation is that FOMC members were eager to cool market concerns that the Federal Reserve will have no choice but to start hiking rates, even if only as of 2022, and to ultimately cap Treasury yields or at least slow the recent increase in long-end yields. To some extent they succeeded, even if only very briefly. Two and five-year Treasury yields closed down 1.4bp and 2.7bp, respectively, on 17th March while the 10-year yield closed up only 2.5bp (see Figure 2).
Bond, equity and crude oil markets unconvinced by Fed’s forecasts and policies
However, this still very dovish Federal Reserve policy rate outlook jars, at least at first glance, with its updated forecasts for US inflation and particularly GDP growth. The Federal Reserve revised up its end-year forecast for core Personal Consumption Expenditure inflation – its preferred inflation measure – to 2.2% from 1.8% and materially bumped up its 2021 GDP growth forecast to 6.5% from 4.2%. The Federal Reserve’s twin arguments are seemingly that i) rapid economic growth this year will not be very inflationary due to slack in the economy (particularly in the US labour market) and ii) that following a period of inflation-undershoot it is willing to accept a modest overshoot in PCE-inflation above its long-term forecast of 2%.
The latter will have come as little surprise. Federal Reserve Chairperson Powell, in his opening speech at the “virtual” gathering of central bank governors on 27th August announced that going forward the Fed would “seek to achieve inflation that averages 2% over time” and therefore that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” He specified that the “Fed was not tying itself to a particular mathematical formula that defines the average” (see US: Much ado about nothing, 28th August 2020).
The arguably more contentious issue, in our view, is the Fed’s prognosis that core PCE-inflation will rise only modestly from 1.5% yoy in January to 2.2% yoy by end-year before stabilising around 2% in 2022 and 2023, despite US GDP growth of respectively 6.5%, 3.3% and 2.2% (see Figure 3). To put it in perspective annual US GDP growth has only exceeded 6.0% four times in the past sixty years (in 1984 and three times in the 1960s) and averaged only 2.1% between 2000 and 2019 (see Figure 4).
The question, which we would break down into four inter-related parts and will address in forthcoming FIRMS reports, is:
1. Whether, when and how fast US households and corporates will spend the cash they have accumulated in the past year;
2. The extent to which there is slack in both the labour market and productive sector;
3. Whether corporates price goods and services aggressively to regain market share or conversely whether they can raise prices in a bid to boost lacklustre revenues; and
4. Whether workers can bump up wage demands in the face of higher inflation and the extent to which this in turn feeds to through to consumer demand and finally CPI-inflation.
The reaction, particularly in longer-end Treasuries, suggests in our mind that bond markets are not convinced that ultra-low US policy rates for the next three years and rapid economic growth (at least this year) can go hand-in-hand with inflation broadly in line with the Federal Reserve’s target. The benchmark 10-year Treasury yield closed up 6bp yesterday to 1.71% – the high since 22nd January 2020 – and has only edged slightly lower today at time of writing. The five-year Treasury yield has exhibited a similar dynamic. As a result the 2s-5s and 2s-10s yield spreads, currently about 69bp and 153bp, respectively, are hovering near their highs since March 2017 and November 2015 (see Figures 5 and 6).
The fact that the Federal Reserve has stepped up its Treasury purchases in the past couple of months suggests to us that it is not convinced that its forward guidance on policy rates will be sufficient to rein in Treasury yields (see Figure 7). The bearish steepening of the Treasury yield curves and overall volatility in yields tells us that bond markets are not yet convinced that larger bond purchases and dovish forward guidance are sufficient in the context of the Fed’s macro forecasts.
Moreover, the collapse in the price of crude oil yesterday (-6.9%) and correction in US equity markets (particularly the tech-heavy and more risk-sensitive Nasdaq) are clear pointers that markets remain concerned about the impact of higher US yields on global demand and equity valuations.
FX markets more sanguine…thanks in part to a little help from Fed’s friends
Global FX volatility has risen in the past 72 hours but remains in line with its 10-year average, according to our calculations (see Figure 8). Moreover, FX markets’ overall directionality has if anything confounded expectations that higher US yields typically weigh heavy on more risk-sensitive currencies, particularly high-yielding emerging market currencies. Admittedly, central bank policy decisions beyond US shores have helped underpin currencies in our view.
The Dollar, in Nominal Effective Exchange Rate (NEER) terms, appreciated a modest 0.3% yesterday – its negative correlation with the S&P 500 a familiar pattern in the past year – and is at time of writing down only very marginally (see Figure 9). The bottom line is that the “safe-haven” Dollar has moved very little in the past six sessions, with the NEER up about 1% in the past five weeks. This is line with our view that the Dollar’s correction in early February was a “short-term correction, with another prolonged Dollar downtrend still a couple of months away” (see Dollar’s recent weakness – Blip, not new trend, 12th February 2021).
Turning to individual currencies, only six out of 32 major currencies have appreciated or depreciated by more than 1% versus the US Dollar since close of business on 16th March, according to our estimates (see Figure 10). The following developments are not particularly surprising, in our view:
- The Russian Rouble has underperformed (-1.6%), dragged lower by the collapse in the price of crude oil yesterday, although the USD/RUB cross has remained within its narrow 6-week range of just 2.5%.
- Asian currencies, with at a stretch the exception of the Taiwan Dollar, have moved very little – in part testament in our view to Asian central banks’ ongoing willingness and ability to dampen currency volatility and guide their currencies via FX intervention.
What is more surprising at first glance is that four of the top five performing currencies are high-yielding emerging market currencies: the South African Rand, Mexican Peso, Brazilian Real and in particular the Turkish Lira. We ascribe the appreciation in the Real and Lira to the larger-than-expected policy rate hikes which the Brazilian and Turkish Lira delivered at their policy meetings this week and their hawkish forward guidance. We would argue that the Mexican and Chilean Pesos and South African Rand have rallied partly in sympathy.
- The COPOM hiked its policy rate 75bp (versus 50bp priced in) from a record-low 2.00% to 2.75% on 17th March and signalled a similar move at its May meeting.
- The CBRT hiked its policy rate 200bp (twice what markets were pricing in) to 19.00% on 18th
The risk now, in our view, is that markets redouble their attention on central banks which they perceive as being “behind the curve” in terms of their policy rates relative to current/expected domestic inflation rates and on currencies vulnerable to sharp commodity pull-backs.
We would argue that the Norwegian Krone, which had until last week been slowly edging stronger (in line with our view), is one such currency. Norway’s economy is highly geared to the international crude oil price and the Norges Bank’s “real” policy rate is the lowest among major developed economies according to our estimates (see Figure 11). The CE3 currencies – the Czech Crown, Hungarian Forint and Polish Zloty – may also come under greater market scrutiny given that their central banks’ real policy rates are amongst the most negative among major economies. We will explore this theme in greater detail in our next FIRMS report.
[1] Up to 19 monetary policy makers – the seven governors on the Federal Reserve Board and the presidents of the 12 regional banks – can contribute a dot.
