Why all eyes are on the Fed

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The Federal Open Market Committee meets Sept. 25 and 26 and will raise the fed funds rate 25 basis points to a target of 2% to 2.25%. That’s clear to Fed watchers. But the FOMC will address a host of other issues whose outcome isn’t as certain.

The meeting will result in a new Summary of Economic Projections, or dot plot, with an updated view of members’ expectations for rates and the economy.
“Markets are pricing in 100% probability of a tightening next week and 80% probability for December,” Arthur Bass, managing director, fixed income finance and rates at Wedbush Securities. “There will be attention as to whether ‘accommodative’ is retained in the statement, as well as the dots — how many moves they project for next year.”The Fed will raise rates “two more times this year and probably an additional four times next year,” according to Steven Friedman, senior economist at BNP Paribas Asset Management.

The post-meeting statement could be tweaked to say the stance of monetary policy is somewhat accommodative in preparation for striking any mention of accommodative in December, Friedman said in a Bond Buyer podcast. Removing the language after this meeting “strikes me as a bit early. I think December is a more likely bet.”

Treasury yields rose in advance of the meeting “as investors perceived increasing odds of further Federal Reserve interest rate hikes, Bill Merz, director of fixed income at U.S. Bank Wealth Management, wrote in a recent commentary. “We continue to recommend shortening maturities since the Fed is likely to increase rates more than the market currently prices in and the yield curve offers little incremental compensation for longer maturities,” he wrote.

As the Fed raises rates, short-term yields will climb. Market expectations have lagged Fed expectations regarding the speed and extent of further rate hikes,” he wrote. Only recently, “investors began pricing higher odds of the Fed hiking at both their September and December meetings. Markets now price a total of three to four hikes between now and year end 2019 (+0.92 percent of further tightening) compared to our expectation for four to five additional rate hikes (1.00 percent to 1.25 percent of further tightening). Bond prices are likely to remain under pressure as the market prices in additional hikes.”

With the core consumer price index at 2.2% in its latest read, there’s “little room for error for the Fed,” said Bryce Doty, senior portfolio manager at Sit Fixed Income Advisors. “We still expect four rate increases total this year [two more by yearend] and two more in the first half of next year until the Fed reaches a 3.0% neutral rate. Our forecast may be too low, though, after two members of the Fed have now cautioned that they may need to raise rates above the neutral rate.”

The FOMC’s tone will remain “hawkish,” according to Jason Ware, managing director and head of institutional trading at 280 CapMarkets. He said the coming rate increase “is priced into the market, maybe a little overpriced and you could see some yield consolidation.”

Should “the economy falter in the backdrop of a hawkish Fed,” the yield curve could invert, he said. “Based on the strong economic momentum we are seeing right now that is something that would not play out until the middle of next year.”

If data and corporate earning remain strong and surprise to the upside, Ware said, “I do not believe you will see an inversion but rather a steepening of the yield curve. On the flipside if the Fed continues down this hawkish path and the economy shows signs of weakness a curve inversion will be likely.”

While inversion has historically signaled a recession, Ware said, “I do believe if the curve inverts this time it could be different,” because the Fed is watching and could change its path and cause the curve to steepen.

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