Posted by on May 24, 2017 5:00 pm
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Categories: Banking Business central bank China CPI Economic history of the Netherlands Economy EuroDollar FED Federal funds rate Federal Open Market Committee Federal Reserve System Finance Financial services Futures contract Gross Domestic Product Janet Yellen Minneapolis Fed Neel Kashkari Shadow Banking Trump Administration unemployment US Federal Reserve Volatility Wall Street Journal

Despite a near-collapse in the US economic surprise index – a key leading indicator, and major negative for the US economy…

… and recent disappointing inflation readings, largely attributed to the telecom sector in general and unlimited phone plan packages, not to mention the 0.7% Q1 GDP print, today’s FOMC minutes scheduled (released at 2:00pm today with the usual 3 week lag) are likely to reveal a relatively optimistic Fed with many Committee members expecting the weakness early on in 2017 to prove “transitory.” 

Points of focus in the minutes will include future plans for the balance sheet (with reduction coming under increased scrutiny in recent times), after minutes of the March meeting showed that many of the policymakers thought a change in the Fed’s reinvestment policy would “likely be appropriate later this year.

As a reminder, Fed officials left the interest rate unchanged within a range between 0.75% and 1% at their May 3 meeting, whose minutes could indicate whether they are preparing to lift it by a quarter percentage point at their next meeting June 13-14.  As such, traders and analysts will will be combing through the minutes to better understand the Fed’s current contraditory, and clearly non-data dependent assessment of the country’s growth and inflation, as well as policymakers’ forecast for activity going forward in the remaining seven months of the year.

Also according to Stifel’s Lindsey Piegza the market will also be looking for clues in the latest minutes as to the Committees’ likely handling of the $4.5T balance sheet. Some analysts have anticipated specifics of a tapering to be revealed in the May FOMC minutes; while the conversation of shrinking the Fed’s balance sheet was no doubt readdressed at last month’s meeting, details or a conclusive pathway are unlikely to be unveiled.

Addressing the balance sheet with a scheduled taper of monthly purchases will no doubt impact the pace of additional interest rate increases, slowing the pathway to reaching the expected terminal level on the Fed funds rate, as tapering itself will be seen as a de facto act of tightening. In other words, if the expected terminal rate on Fed funds is 3%, as many officials have suggested, and the anticipated timeframe of reaching said level is around two to three years, now, addressing the balance sheet during that same period could extend the timeframe from reaching the terminal level to five years, maybe more. Nevertheless, at the point, according to Bloomberg, the probability of a rate hike at the upcoming June 14th FOMC meeting remains elevated at near 100%.

In addition to the above, here are five things to watch for courtesy of the WSJ:

1. How Likely Is a June Rate Increase?

The Fed last raised short-term rates in March, and it penciled in two additional quarter-percentage-point increases this year. June offers a good opportunity for another move: The meeting is followed by a press conference by Chairwoman Janet Yellen, and raising rates a second time in the first half of 2017 would give officials more time to evaluate how the economy evolves before considering a third increase in the second half of the year. Expectations for a June rate increase are high. A recent Wall Street Journal survey found 88% of economists expected such a move. Traders in futures markets place an 83% likelihood of a move in June, according to CME Group. The minutes could either confirm or confound that expectation. 

2. Weak Economic Growth

One argument for holding off on a June rate increase could be the economy’s mixed performance since March. Inflation wobbled recently: The Fed’s preferred inflation gauge, the price index for personal-consumption expenditures, briefly exceeded the Fed’s annual 2% target in February but slipped below it again in March, as prices rose 1.8%. Economic growth in the first quarter also disappointed, with gross domestic product expanding at a 0.7% annual rate. However, the Fed said in its May policy statement that the slowing was “likely to be transitory,” suggesting the central bank wasn’t overly worried about the slump. Also on the plus side, the unemployment rate has fallen further since the Fed last raised rates, to 4.4% in April, its lowest level in a decade. The minutes could provide more detail on officials’ assessment of the economy’s health.

3. Slimming the Balance Sheet

A point of interest in the May minutes will be officials’ discussion of how and when to start shrinking the Fed’s portfolio of bonds and other assets. Minutes of the Fed’s March policy meeting indicated officials wanted to begin the process by the end of the year, but questions remained over the pace of reductions and the size of the holdings when they finish. The Fed’s balance sheet has grown to $4.5 trillion, or around 23% of U.S. gross domestic product, from less than $1 trillion, or around 6%, before the financial crisis. Reducing its size without roiling markets will be a delicate task. Officials in March were careful to note they wanted to proceed in a “gradual and predictable” way, likely to avoid a rerun of the 2013 “taper tantrum,” when the prospect that the Fed would slow its asset purchases set off market volatility, including a spike in Treasury yields and large capital outflows from many emerging-market economies.

4. Fiscal Policy

Fed officials continue to assess whether the Trump administration’s proposed tax cuts, spending plans, regulatory changes or other policies could boost economic growth and drive up inflation. Minutes of the Fed’s March meeting showed most officials saw a possibility that the economy could perform better than they expected because of possible new tax and spending policies. Minutes of the May meeting could provide a more recent snapshot of their thinking.

5. Challenging Assumptions

A couple of Fed officials have cast doubts on the strength of the labor market recently, and that will be a point to watch in the minutes. Although the unemployment rate hit an ultralow 4.4% last month, there hasn’t been a breakout in inflation. Economists would usually expect inflation to rise when joblessness gets low as companies compete for scarcer workers by offering higher wages. Over the past few weeks, several Fed officials have said the labor market has returned to full employment, which means essentially every worker looking for a job can find one. But two officials, Fed governor Lael Brainard and Minneapolis Fed President Neel Kashkari, have expressed doubts about that in recent days, arguing there might be further room for improvement in the labor market since the low joblessness hasn’t meaningfully boosted prices. Details of this debate could show up in the May minutes, and could indicate some officials might be inclined to keep rates lower for longer to help push up wages.

Additionally, BofA highlights 4 issues which could hinder the Fed’s plans going forward:

  1. First and foremost, China is trying to reign in its shadow banking system and there is a risk of “overshooting,” damaging growth.
  2. The markets seem quite complacent about the Fed.
  3. Next year’s likely end to QE in the Euro Area.
  4. Have interest rates really been too low for too long? Economic slack and muted inflation suggest otherwise

Of the above, #2 may be most important as the Fed has increasingly warned that stocks are getting ahead of themselves, and it is possible that Yellen will hike just to take out some of the froth in stocks.

Finally, in terms of market reaction, Bloomberg points out that the latest CFTC data shows the most extreme speculator positions currently sit in 10Y futures, which recently grew to heaviest longs since January 2008, while futures positioning remains near record shorts across eurodollars. This turnaround in speculator TY longs has been sharp, following the biggest short unwind on record that occurred three weeks ago.  On the other end, speculator Eurodollar shorts remain near record levels.

The conclusion is that near record long TY coupled with short eurodollar positioning among speculator accounts leaves the market open to exacerbated moves.

This means that a dovish take on the minutes may see sharp short-covering across front eurodollars, leading Treasury prices higher further out the curve, while a hawkish outcome could see intermediates out to 10s lead a wider move lower in price as accounts look to take profits on recently built-up longs.

Finally, a potential reason for dovish take may be soft CPI and retail sales data from May 12, while a dismissal of the data as “transitory” may result in a more hawkish view. Going into the minutes, current odds of a June hike based on OIS probabilities sit at 76%; a full hike and further 4bp is priced in for September; almost 1.5 hikes is priced in by year-end.

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