Don’t ignore FOMC meeting just because Fed’s on hold
While the fed funds rate target will remain at a range of 1.50% to 1.75% and there will be no new Summary of Economic Projections, the Jan. 28-29 Federal Open Market Committee meeting may offer insight into areas that may become problematic as well as its thinking on the balance sheet, analysts suggest.
"It is likely the Fed will increase both the interest on excess reserves (IOER) and the repo offered rates by five basis points to 1.60%,” said Bill Zox, portfolio manager and chief investment officer, fixed income, at Diamond Hill Capital Management. “But the most important issue for the Fed is how to extricate itself from the repo market. It is possible — but not probable — that the press conference will shed some light on this issue. The repo market must once again stand on its own and a byproduct of the Fed’s temporary solution is the melt-up in asset prices which could lead to dangerous financial imbalances."
Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, suggested the IOER “could be raised to 1.625%, the mid-point of the fed funds target range and the ON RRP could be increased to the lower end of the target range at 1.5%. The aim would be to lift the effective fed funds rate back to 1.625%, the mid-point of the target range.”
A plan could be proffered to normalize the level of bank reserves, she said. “Currently the Fed has maintained $60 billion per month of T-bill purchases and conducting large, overlapping repo operations to inject large amount of reserves (cash) into the banking system.”
Going forward, Oxford sees “sub-potential GDP growth of 1.6% (Q4/Q4) in 2020 and continued below-target inflation that should prompt a ‘material reassessment’ of the Fed’s economic outlook,” Bostjancic said. “This should lead to another 25-basis point rate cut by mid-2020.”
With the bar being higher for a rate hike than a cut, the market “is potentially exposed to a hawkish surprise from the Fed, whether it is communicated intentionally or not,” said Jason Celente, senior portfolio manager at Insight Investment.
“One hint towards a surprise would be any acknowledgment of financial excesses as equity and credit valuations are near historical highs,” he said. “We think that the Fed is still vigilant on this ‘third mandate’ although delivering this message is a delicate proposition during an election year. The recent market pause due to the developing coronavirus situation may ultimately give the Fed reprieve from commenting on financial conditions this time around, but we feel that it could be a story at some point in the not-too-distant future.”
While “further rate cuts are highly unlikely” at this point, Sarah Bauder, senior market analyst at SophisticatedInvestor.com, said, any discussion of “the Fed’s balance sheet will be something to watch for, as it denotes whether [the panel’s] economic concerns have been truly alleviated.”
Steve Skancke, chief economic advisor at Keel Point and former Treasury staffer, agreed. “The Fed continues to add liquidity to the financial system — the Fed balance sheet is up around $400 billion since the repo problems last fall,” he noted. “The Fed struggles to say this is not quantitative easing, notwithstanding the fact that it is. The Fed will need to address this more directly or offer a better alternative for maintaining a well-working repo market.”
Of concern to the Fed will be inflation. “The Fed will be looking for some indicators that the inflation rate is not declining or showing signs of weakness,” Skancke said. “While it is not telegraphing concerns about deflation, it remains watchful, especially because of continuing weakness in Europe.”
Discussing the Fed’s increasing balance sheet, which some have called quantitative easing, although the Fed has strongly rejected the moniker, Franklin Templeton Fixed Income CIO Sonal Desai says, “What we call it isn’t the point. What matters are the implications of this ‘permanently loose’ policy stance for asset prices, investment strategy and market volatility.”
Since the markets consider this QE, “if the Fed stops buying assets, [the markets] will mistake it as a policy tightening,” she said in a blog.
“I don’t think it’s just perception — expanding the Fed’s balance sheet has an actual impact, just as it did when the Fed called it QE.”
Her takeaway: that September’s repo market issues “came as such a surprise to everyone, including most importantly, the Fed, should concern us” since it raises the possibility “other ‘unknown unknowns’ lie in the nexus of new regulations and what seems to be a permanently loose monetary policy stance.”
Overall, this year may be less volatile than last, given the approaching elections, said Mark Heppenstall, CIO at Penn Mutual Asset Management. The Fed will “step to the side prior to the election and will let inflation numbers ‘run hot’ before reacting — should growth disappoint, easier policy is more likely to come in the form of balance sheet expansion as opposed to rate cuts.”
With “five-year real yields in negative territory,” he added, the Fed is “likely to err on the side of too easy as opposed to restrictive.”
The economy is nowhere near a level that would cause a “material reassessment,” said Greg Staples, head of fixed income, Americas at DWS Group. “There is a growing strong reluctance to move as we get closer to the election.”
Staples noted the rotation of regional bank presidents with voting power makes the new regime “a bit more dovish, with hawks Eric Rosengren and Esther George rolling off as voting members, replaced by more moderate Loretta Mester and Pat Harker. Outgoing dove [James] Bullard is offset by incoming uber-dove Neel Kashkari.”
Fed Chair Jerome Powell could face questions from the press about the liquidity issues and if there is a strategy to unwind it, and whether the Board is “concerned about Financial Stability (loose monetary policy inflating securities prices).” Staples noted Dallas Fed President Robert Kaplan recently voiced a concern, as had Rosengren previously.
With the Phase One trade deal with China signed, Greg McBride, senior vice president & chief financial analyst at Bankrate, says he expects Powell will be quizzed “about the rising stock market since the Fed began supporting the repo market and expanding its balance sheet." While the Fed keeps noting “inflation is too low,” he added, “that risks missing the forest for the trees if wage inflation and tariffs feed through to broader price levels."
Bill English, professor at the Yale School of Management and former heard of the monetary affairs division at the Fed, expects the bill purchases the Fed has made to support the repo market “and what level of reserve balances they want to operate with,” will be discussed at the meeting. “It’s possible that they will indicate when the bill purchases are likely to end, but a final decision on that can wait until the March meeting.”
With the markets seeing the purchases as QE, “any communication about the end of those purchases could be market sensitive,” he said. And while it will be discussed, and included in the minutes, English doesn’t expect “a formal decision at this meeting.”
As an aside, English sees the Fed’s point. “The QE purchases were of longer-term securities, with the intention of pushing down term premiums and longer-term interest rates,” he said. “Bill purchases don’t have that effect.”
Also on the agenda will be “policy tools, framework, and communication,” but nothing will be disseminated until the minutes are released, he said.
“Increased transparency from the Fed, along with Brexit and trade developments, has been the biggest driver of the recent market rally,” said Nick Giacoumakis, president and founder at New England Investment and Retirement Group. “Eliminating uncertainties bodes well for markets.”
“The consensus seems to be that the Fed is on pause for the time being,” said Tony Bedikian, head of Global Markets, Citizens Bank, “as policymakers have achieved a balance between low unemployment and moderate inflation in a slow, steady growth environment.”
So what lies beyond this meeting?
Sebastien Galy, senior macro strategist at Nordea Asset Management, expects two or three rate cuts by July due to a slowing economy. “Capital investment should continue to be a drag as CEOs’ expectations remain depressed, though over time their favorite market, namely China, should improve.”
While government spending will be steady, “the open question is consumption,” he said. “It was still robust in December helped by some price discounting and a tight labor market. It is there that we expect some easing, though still at robust levels.”
Morgan Stanley Research expects “a general message that the outlook is sound, trade appears to be moving in a positive direction, but uncertainties remain.” The rotation of voters will not change the Fed’s stance and the IOER rates will be held.
“The balance sheet will take center stage, both in discussions and in Powell's press conference,” they suggest. “Clearer communication is needed to allay concerns among investors that an end to building reserves will pull the rug out from under risk assets. The Fed aims to enter the spring with ample reserves and does not see its purchases of T-bills as a key factor in driving risk assets higher.”