The Key Things To Look For In Today's FOMC Minutes

Looking at today"s scheduled release of Minutes from the September FOMC meeting (which at least according to one trader will be the "start of the market changeover process"), RanSquawk reminds us that the Federal Open Market Committee stood pat at the meeting, as expected. The Committee also announced that it would begin to shrink the size of its balance sheet in October, as expected, with the process falling in line with a previously disclosed detailed plan. Additionally, the summary of economic projections saw the FOMC trim its "longer run" Federal Funds target rate expectations, while the nearer-term core PCE projections were also trimmed, and GDP estimates were raised.

With that in mind, here is what Wall Street expects from the minutes to be released at 2pm ET today, courtesy of RanSquawk.

RBC suggests that the “debate surrounding the drop back in core inflation this year was particularly lively. The bounce-back in CPI inflation appears to have convinced the centrists that the earlier weakness was partly due to transitory factors, whereas the doves are still worried about potential structural factors or lingering cyclical slack.”  This was reflected by the fact that 12 of 16 officials that submitted projections still anticipated at least one more rate hike this year.

In the press conference that followed the decision Fed Chair Janet Yellen noted that “low inflation this year, despite a substantial improvement in labour market conditions, created uncertainty for monetary policymakers.” Although she did note that low inflation may be “transitory” and as a result it does not negate the need for gradual policy tightening.

Since the decision, Fed rhetoric has increasingly cited structural headwinds for inflation, while some of the more dovish members have continued to highlight the need for a pickup in inflation before they are willing to vote for a hike (including 2017 voter Robert Kaplan, who was previously of a hawkish disposition).

Markets still lag the FOMC in terms of rate hike projections, pricing circa two 25bps hikes through the end of November 2018, will the median FOMC projection looks for four 25bps hikes through the end of 2018.

Focus has switched to the race to be the next FOMC Chair, with four notable frontrunners in contention at present (a primer is available here), with Barclays outlining their perceived monetary policy stances in the image below.

Deutsche Bank provided the handy crib sheet seen below, summarising what a victory for each respective front runner would mean across for Fed policy.

What The Bank Desks Are Saying: –

Barclays: Given the outcome of the September FOMC meeting, in which only four participants indicated no further rate hikes this year was appropriate, we expect the FOMC minutes to show that most participants see recent disinflation as largely driven by transitory factors. We expect the discussion to remain focused on inflation and its shortfall relative to what the Fed’s Phillips curve framework would suggest, but we believe most participants will view the unexplained weakness as dissipating over time, thereby permitting a return of inflation to the target. The minutes may indicate that members preferred to reduce their estimate of the longrun neutral rate of interest as opposed to halting the normalization process. Elsewhere, we expect the minutes to include discussion as to why it was time to begin balance sheet runoff and how members see the balance of risks to the outlook for the US economy.

Deutsche Bank: Inflation will likely be a heavily debated topic, but given the recent Fedspeak, it appears that most voting members are looking through some of the recent weakness and prefer to continue the “gradual” removal of monetary accommodation.

HSBC: The FOMC announced in September that it would initiate its balance sheet normalisation programme in October, as described in the June 2017 addendum to the committee’s “Policy Nomalization Principles and Plans”. The operational parameters of the programme had been communicated to financial markets in advance and did not come as a surprise. We will look through the September minutes to see if there was any further discussion regarding the expected impact of balance sheet disinvestment. Inflation was likely a major topic of discussion at the September FOMC meeting. In the conference following the meeting and in a subsequent speech, Fed Chair Janet Yellen noted that low inflation this year, despite a substantial improvement in labour market conditions, created uncertainty for monetary policymakers. In the end, the Chair concluded that low inflation may be “transitory” and that it had not persisted long enough to negate the need for gradual policy tightening. However, some other FOMC policymakers have indicated a preference for allowing inflation to pick up before raising policy interest rates any further. The FOMC minutes are likely to show a range of views on inflation, financial stability, and the implications for policy.

Morgan Stanley: The FOMC minutes are often revised nearly all the way up until the release and can be edited to stress important points. We look for the Fed to resume its gradual path of rate hikes again in December.

Watch Live: Hawkish Yellen Says Fed May Have Misjudged Inflation, Labor Market

Update: In her prepared remarks, Yellen crucially said,

“A more important issue from a policy standpoint is that some key assumptions underlying the baseline outlook could be wrong in ways that imply that inflation will remain low for longer than currently projected.”

As Bloomberg explains, she is stating a bit more clearly than before that the FOMC doesn’t have a handle on why inflation is low and acknowledging that it may last longer than they predict.

*  *  *

As we detailed earlier, on the heels of Bostic ("we didn"t blow any bubbles") Brainard ("some barriers to growth are structural") this morning and Kashkari ("no inflation"), Evans ("need more data"), and Dudley ("inflation"s coming soon") yesterday; it is Fed Chair Janet Yellen"s turn to speak this afternoon on "Inflation, Uncertainty and Monetary Policy" as the dollar extends its post-FOMC gains (to 1-month highs).

Since The FOMC, Fed Speakers have been active...

Raphael Bostic, Atlanta Fed president: "I actually don’t think that our policies are too easy in the sense of really facilitating some sort of asset bubble."

Lael Brainard, Fed governor: Benefits of a lengthy U.S. recovery “can only go so far” and some barriers appear to be structural, sees "widening gulf" between large, small cities.

Neel Kashkari, president Minneapolis, FOMC voter in 2017: “I don’t see inflation taking off so I see no need to tap the brakes.”

Charles Evans, president Chicago Fed, voting member: “I think we need to see clear signs of building wage and price pressures before taking the next step in removing accommodation.”

William Dudley, president New York Fed, permanent voter (and most notably considered to be closely aligned with Yellen"s way of thinking): “With a firmer import price trend and the fading of effects from a number of temporary, idiosyncratic factors, I expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term.”

As a reminder, the Fed Chair said that "we don"t fully understand inflation" and added that the "shortfall of inflation this year is more of a mystery," but, while Yellen speaking would normally be must-watch, with only a few days having passed since her post-statement press conference, we wonder just how much flip-flopping is possible. At that appearance, the Fed chief also downplayed the significance of the weak core inflation data as the central bank set the start date for the reduction of its balance sheet and signaled that an additional rate hike this year remained appropriate.

Additionally, though we doubt she will comment on it, Republican Senator Richard Shelby said he doesn’t think President Donald Trump will nominate Yellen for a second term at the helm of the U.S. central bank. Shelby said Tuesday in an interview with Bloomberg Television’s Vonnie Quinnthat he had spoken with the president about the Fed.

“I believe he will appoint somebody else to take her place,” the No. 2 Republican on the Senate Banking Committee said. “But ultimately, that is up to the president.”

Live Feed (from The National Association of Business Economics)

click image for link to Bloomberg"s Live Coverage

Headlines include (via Reuters)

• YELLEN SEES "CONSIDERABLE" ODDS THAT INFLATION WON"T STABILIZE AT 2-PCT OVER NEXT FEW YEARS


• FED"S YELLEN SAYS UNCERTAINTIES STRENGTHEN CASE FOR GRADUAL RATE HIKES


• YELLEN SAYS GRADUAL APPROACH TO RATE HIKES PARTICULARLY APPROPRIATE IN LIGHT OF SUBDUED INFLATION, LOW NEUTRAL RATE


• YELLEN SAYS THERE IS A RISK INFLATION EXPECTATIONS ARE NOT AS WELL-ANCHORED AS THEY APPEAR


• YELLEN SAYS DATA SUGGESTS LABOR MARKET IS HEALTHY, WITHOUT SUBSTANTIAL SLACK AND NOT OVERHEATED


• YELLEN SAYS EVIDENCE ON LABOR MARKET NOT DEFINITIVE, MUST BE "OPEN-MINDED"


• YELLEN SAYS WOULD BE IMPRUDENT TO LEAVE RATES ON HOLD UNTIL INFLATION REACHES 2 PCT


• YELLEN SAYS FED CAN STILL ACHIEVE 2-PCT INFLATION GOAL EVEN IF IT IS UNDERESTIMATING SLACK OR OVERESTIMATING INFLATION EXPECTATIONS


• FED"S YELLEN SAYS LOW INFLATION LIKELY DUE TO TRANSITORY FACTORS, SEES MANY UNCERTAINTIES


• YELLEN SAYS DOWNWARD PRESSURE ON INFLATION COULD PROVE UNEXPECTEDLY PERSISTENT


• YELLEN SAYS FED SHOULD BE `WARY OF MOVING TOO GRADUALLY"


• YELLEN SAYS WOULD BE IMPRUDENT TO LEAVE RATES ON HOLD UNTIL INFLATION REACHES 2 PCT

Via Bloomberg:

Fed Chair Janet Yellen said FOMC may have misjudged fundamental forces driving inflation and strength of labor market, and policy makers “stand ready to modify our views based on what we learn.”

• “We will need to stay alert” and adjust monetary policy as information comes in, Yellen said in text of speech Tuesday in Cleveland during annual meeting of National Association for Business Economics 


• “My colleagues and I must be ready to adjust our assessments of economic conditions and the outlook when new data warrant it”

Downward pressures on inflation “could prove to be unexpectedly persistent”

• Economic outlook is subject to “considerable uncertainty”

FOMC’s understanding of the forces driving inflation is “imperfect,” policy makers recognize “something more persistent” may be responsible for current undershooting of long-run objective

• While inflation will most likely stabilize around 2% over the next few years, “odds that it could turn out to be noticeably different are considerable”


• There’s also risk that inflation expectations “may not be as well anchored as they appear and perhaps are not consistent with our 2 percent goal”

Stabilizing inflation at around 2% “could prove to be more difficult than expected” 

Key assumptions underlying baseline outlook “could be wrong” in ways that imply inflation will remain low for longer than currently projected; for example, labor market conditions may not be as tight as they appear

Under certain conditions, “continuing to revise our assessments in response to incoming data would naturally result in a policy path that is somewhat easier than that now anticipated”

Significant uncertainties strengthen the case for gradual pace of tightening; however, Fed must also be wary of moving too gradually; “it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent”

Actual value of long-run sustainable unemployment rate “could well be noticeably lower” than FOMC currently projects; can’t rule out possibility that some slack still remains in labor market

• Unemployment rate is probably “correct” in signaling that labor-market conditions have returned to pre-crisis levels; however, that doesn’t necessarily mean that economy is now at full employment


• Data suggest a generally healthy labor market, although can’t make “any definitive assessment”; policy makers “must remain open minded on this question” and its implications for reaching inflation goal 

FX Traders Haven't Been This Worried About An FOMC Meeting Since Last Year

While equity implied vols are compressed to record lows - what could possibly go wrong with unwinding a $4 trillion balance sheet? - it appears FX traders are a little less sanguine about the market"s reaction to today"s FOMC decision.

And more specifically, one-day volatility in euro-dollar options surged to the highest level for the day of a Federal Reverse monetary-policy decision this year, suggesting elevated expectations among investors.

As Bloomberg notes, the raised level of the gauge suggests traders see a good chance of the euro breaking out of its recent range should Chair Janet Yellen surprise the markets on the outlook for Fed policy.

The probability of another U.S. interest-rate increase by year-end is over 50 percent, according to the overnight indexed swap curve.

Jackson Hole Preview: Market Reactions, And Why UBS Says "Don't Skip Lunch"

Historically the annual Jackson Hole symposium has been a major market-moving event as it has traditionally been the venue where central banks make critical announcements such as Bernanke"s preview and hints of QE2 and QE3 in 2012, as well as Draghi"s suggestion of the ECB"s QE in 2014. As shown in the chart below, market reactions following these events have been material.

This year, however, while there was a sharp build-up in expectations after several media trial balloons suggested that Draghi would unveil the ECB"s taper, the fact that the market sent the EUR just shy of 1.20 in frontrunning of this announcement, prompted the ECB head to abort the entire affair, "leaking" that no material announcement would be made this week in Wyoming after all. Which is why, in previewing potential market moves, Barclays says that "the risk for the EUR around the event is biased to the downside, and that EUR bulls might be disappointed by a lack of meaningful hints on ECB monetary policy normalisation."

ING is quick to take the fun out of this week"s annual meeting: "this year"s major speakers, Fed Chair Janet Yellen and the ECB President Mario Draghi, are likely to keep their cards close to their chest. Both speeches are likely to be fairly "high level" and lack any major hints about future policy."

As Deutsche Bank"s Jim Reid echoes, "there might be a few less nerves about the next few days in markets than many felt a few weeks ago. Back then, Thursday"s commencement of the annual Jackson Hole Symposium seemed to be a natural place for Mr Draghi to signal that exit from QE was soon to be accelerated. However a combination of still soft global inflation data and the Euro"s recent ascent has made it unlikely that the event will be a watershed moment. Expect him to be upbeat on the economy but the hawkish/dovishness indicator might be swayed one way or the other on how much attention the Euro gets in his remarks."

What about the Fed side of things? Here, according to UBS there will be nothing of market-moving either, and as the bank"s economist Seth Carpenter writes "Don"t expect news at Jackson Hole. Chair Yellen has told us what she wants to about normalization, for now. Financial stability matters, but it isn"t new" and as such it will be "nothing to skip lunch over."  Carpenter elaborates that "the annual Jackson Hole Symposium features Chair Yellen on Friday speaking on "Financial Stability." The conference has in recent years been a venue for big news in monetary policy, but this time around it is likely to be undramatic. We expect the Chair"s speech to keep to well-trod financial stability topics—some excesses may exist, but the system is safe—and eschew discussion of potential near-term policy actions."

Deutsche Bank is a little less sanguine:

Our Fixed Income Strategists now actually think that the Fed could be more important at Jackson Hole. The running theme of this year’s symposium is “Fostering a Dynamic Global Economy” and the full line up of speakers and presentations will be released at 4PM EST on Thursday. Mrs Yellen will be speaking Friday morning at 10AM EST on financial stability. Our strategists noted that in the US there is a tension between softer inflation and easy financial conditions and given the topic of Yellen"s speech is "financial stability" she may lean towards prioritising one side or the other. Overall the market will probably be most sensitive as to whether a December hike is more or less likely after her comments. The imminent halting of reinvestment seems to be considered a fine deal."

But why is UBS convinced that Friday"s events (a full logisitcal breakdown is below) will be a snooze fest? Here is the explanation"

The FOMC has told us what they want us to know on monetary policy

The FOMC has increased its communication and transparency about the normalization of its balance sheet. The big news is out. The outlook for rate hikes, Chair Yellen and the FOMC have told us, depends on the realized and expected path of inflation. Some technical details about implementation remain to be disclosed, but Jackson Hole would not be the venue. The FOMC has also been clear that they will put off decisions on the terminal size of the balance sheet until after implementation has begun.

"Financial stability" matters, but isn"t new

As we noted, the Minutes of the June and the July meetings both discussed financial stability issues. In July, "a number" of participants noted that very low long-term yields could snap back abruptly or induce excessive risk taking. Moreover, the FOMC discussed equity valuation as a possible source of financial instability along with commercial real estate. On net, however, the FOMC seems comfortable with current financial stability risks, even though they will continue to monitor developments.

So what will she say about financial stability?

We suspect that Chair Yellen will take this opportunity to discuss the distinction between financial stability considerations and financial conditions more broadly. She will take stock of the signal from historically low interest rates and the forces that determine those rates. These factors include slower potential GDP growth than historically was the case, global savings demand for very safe assets, and the Fed"s balance sheet that continues to put some downward pressure on rates. She will note that equity valuations are high by some metrics, but by others may be justified. She will spend time on tight credit spreads, especially in the context of the Fed"s monetary policy, the ongoing expansion, and generalized risk taking. Finally, she will acknowledge that parts of the Committee see commercial real estate as potentially pointing to excessive risk taking.

Well, what about financial conditions?

The Chair will take some time to differentiate financial conditions from financial stability concerns. The high level of equity prices, tight credit spreads, and low longer-term Treasury yields are much in discussion. She will note that the easy financial conditions are not, in and of themselves, a problem for monetary policy. Rather, they are one factor among many that inform her outlook for the economy. Easier financial conditions should, all else equal, support aggregate demand. In fact, as noted in Fedspeak, the Committee"s outlook for ongoing gains and higher inflation over time is supported by these conditions, not hampered by them.

What should we take away?

Very little. Overall, Chair Yellen"s speech will articulate more clearly how the FOMC thinks about financial stability issues, there should be very little that informs us on the near-term outlook for monetary policy. She will likely reiterate that the post-Crisis regulation has made the system safer. She will embrace the idea that there is room for some adjustment to the existing regulation, but she will push back against the idea of wholesale financial deregulation.

Of course, if UBS is right, any hopes of a spike in cross-asset volatility at the end of the week can be postponed yet again. Market outcomes aside, what is the agenda and logistics? Here, courtesy of Goldman, is a full breakdown:

Starting with the basics, the conference runs from the night of Thursday, August 24 through Saturday afternoon. Each year, the conference centers around one broad theme (this year it is “Fostering a Dynamic Global Economy”) and all of the presentations should be a mix of current policy discussions and the conference theme.

The full program will be released here on Thursday night at 8pm NY time. In addition to timing, this schedule will include speaker names and the title of papers they will be discussing (if applicable). It is probably worth mentioning that because the conference is in Wyoming, all times are listed in Mountain Time. That is two hours behind the US East Coast and seven hours behind London.

None of the conference is broadcast. For all of the published speeches and papers, text will be released at the scheduled time for the panel or speech and there is no televised Q+A. However, there are usually a series of sideline TV interviews across major business networks. These are conducted throughout the day with a number of Federal Reserve officials (usually around five), international central bankers and academics. Because the speeches often have more of an academic slant, these interviews can  often be the most relevant short-term news events of the day. The last couple years, Vice Chair Fischer has done an interview on CNBC during the first coffee break around 11:30 NY time.

The main events start Friday morning at 10am with the keynote speech, which we now know will be delivered by Fed Chair Yellen. So far, the Fed has only said that her speech will be on the subject of “Financial Stability.” It is obviously hard to forecast a freeform speech, so we will just make a few logistical points.

• First, since it is the keynote speech for the conference, the content of the speech should be closely tied to the conference theme of Fostering a Dynamic Global Economy.


• Second, the subject of the speech alone is not a sufficient indicator for whether or not she will comment on current policy. Last year, the subject of Yellen’s speech was listed as “The Federal Reserve’s Monetary Policy Toolkit” but she decided to include an opening section on the “Current Economic Situation and Outlook” that could just as well have been omitted.


• Third, keep in mind that this is an academic setting above all else. Although Yellen certainly knows the weight that her words carry, the Jackson Hole keynote tends to be 10-15 pages long and can include multiple pages of academic references and footnotes; this is not the kind of thing that is easily distilled into a few news headlines. Last year’s speech, with its explicit section on current policy, was probably an exception to that rule.

The keynote speech is just one aspect – albeit an important one – of a busy conference.

So far, we also know that ECB President Draghi will deliver the luncheon address on Friday at 3pm NY time. The text of his speech should be released at that time. While this could certainly change, the rest of the speaking slots on Friday are usually reserved for academics. In past years, there has also been a closing panel on Saturday around 12:25 NY time that features speeches from two or three G10 central bankers and  one from EM.

On the other end of the spectrum, the academic papers (and the topic of the conference itself) could potentially have the longest-lasting impact on the policy discussion. However, these will also be the hardest to immediately interpret. As with the speeches, the text of the academic papers will not be released until the time of the relevant panel. The title and author names will be on the program released on Thursday night.

As Goldman further adds, given the number of Federal Reserve comments likely to come out of Jackson Hole on Friday, the bank is providing its usual table of recent Fed comments with a bit of a longer history as a quick reference point. For example, Dallas Fed President Kaplan’s comment last week that he is going to be “patient” on future rate hikes was a repeat of comments he made in July.

* * *

Finally, for those who are not convinced that Draghi, who is scheduled to speak on Friday just before the market close, won"t steal the spotlight after all, Deutsche Bank reminds us that the ECB head is warming up for the trip by speaking at the Lindau economics symposium in Germany tomorrow, August 23 "and as such he could front run himself." In other words, tomorrow"s conference could be more market-moving than what happens on Friday.

The Two Things To Look For In Today's FOMC Minutes

There are two, also known as non-GAAP four, things to look forward to in today"s FOMC Minutes: inflation, and balance sheet, balance sheet, balance sheet.

At 2pm, the FOMC will release the minutes of the July 25-26 meeting when, as expected, the Fed left its rate unchanged and gave few surprises in its characterization of the outlook. It did surprise many, however, by noting that it expects to begin implementing balance sheet normalization "relatively soon", language which most had not expected to be introduced until September; this, as UBS notes, is the condition the FOMC set for unwinding its balance sheet, so we now see the Fed announcing its balance sheet normalization policy in September. While there will be no earthshattering revelations, look to the Minutes to shed additional light on the Committee"s debate on this timing and views on the outlook for inflation, which will determine future rate hikes.

Going back to the July 26 statement, the FOMC"s characterization of inflation was uninformative, merely reflecting the softness in the last several prints. In the minutes, some hope to find if the language reflects strongly held views that the softness is transitory, or if there were participants that wanted to raise more alarm about the inflationary outlook, but were outnumbered. Chair Yellen has been explicit that the outlook for inflation will determine the timing of future rate hikes.

Leading up to the meeting, Fed officials were explicit that they believe that inflation weakness is transitory but that they need to see evidence that inflation is rising before hiking again. Further complicating matters, the July CPI print - the fifth miss in a row - did not provide sufficient evidence. As a result, the breadth of inflation views within the Committee should inform the sellside"s calls on the next hike.

As for the Fed"s balance sheet "normalization", the Fed has made a distinction between announcing and implementing the balance sheet runoff. The new "relatively soon" language represents a marker that the announcement is forthcoming, according to UBS. As a result, the FOMC will likely make that announcement at the September meeting, with runoff commencing in October. The Minutes need to clarify the Committee"s communication plans and the gap between announcement and implementation.

There is more ambiguity regarding whether the Fed will again raise rates: while many still hold out hope for a third hike in December, inflation has to accelerate. Still, the Committee likely desires some time between the announcement of balance sheet runoff and its next hike. Three months should be sufficient for the Committee to assess the market reaction, but the Minutes may indicate otherwise so this too will be closely parsed for any indication of a longer pause.

Finally, two areas demand more information.

• First, how will the Fed time the unwind? The MBS market has a different cycle than the Treasury market. The Fed needs to clarify operational details around their monthly caps.


• Second, there is little information from the Fed on its long-term framework for the balance sheet, which will determine the terminal size of the balance sheet. We expect the minutes to address the operational details, but not the terminal size of the balance sheet. We expect a terminal balance sheet of $3.3 trillion reached in 2¾ years.

Not enough? Here is RanSquawk"s detailed preview of what to expect in today"s Minutes:

FOMC’s July 2017 Meeting Minutes Preview, Due For Release At 19:00 London, 14:00 New York On Wednesday 16th August 2017

The July meeting saw the Federal Reserve leave it Federal Funds target range unchanged at 1.00-1.25%, with a 9-0 vote. Heading into the decision focus was on the rhetoric surrounding the normalisation of the FOMC’s balance sheet, and the policy statement (full version available here) noted that the Committee expects to begin shrinking its balance sheet "relatively soon." The statement also saw the Fed highlight that it expected inflation on a “12-month basis” to remain below 2% in the near-term (which was deemed dovish), although the statement did go on to highlight that the FOMC expects inflation to stabilise around 2% over the medium term.

The language surrounding these two areas will once again garner the most attention in the upcoming release. Barclays expect the minutes of the July FOMC meeting to “provide further information regarding the timing of balance sheet normalisation and the degree of consensus within the committee.”

While HSBC believe that “the July minutes are likely to show extensive discussion about the slowdown in inflation over the past several months. Some of the policymakers likely held to the view that diminishing labour market slack should eventually put upward pressure on inflation. Others may have argued the FOMC should be cautious with respect to additional policy rate hikes unless the inflation data start to pick up.”

Since the statement various FOMC voters, namely Dudley, Kashkari, Evans and Kaplan, have indicated that they would be comfortable with an announcement regarding balance sheet normalisation being made at the September meeting, while non-voters (including Bullard) have also backed such a move.

In terms of broader policy issues, the most recent US CPI release (for July) was soft and saw CME Fed Fund futures pricing in a sub 35% chance of one further 25bps hike in 2017, with Kashkari (a noted dove)  arguing that the release gave the FOMC more scope to “wait and see” before hiking rates again. This was before permanent Fed voter, Bill Dudley, suggested that “if the economy evolves in line with expectations, I would expect to be in favour of doing another rate hike later this year.” This was followed by a strong retail sales dataset (with upwards revisions), which has led to CME Fed Fund futures pricing a circa 50% chance of a 25bps hike by year end (at the time of writing).

Barclays believe that “balance sheet normalization will likely start in September and the hurdle is quite high for the FOMC to deviate from what it has been signalling so far. We will also look for more detail on how concerned the FOMC is with the incoming data on inflation. Although we think concern has risen, we do not believe there is sufficient worry yet to derail a likely December rate hike.

Source: UBS, RanSquawk

Is The Fed Poised To Ignite A Violent Dollar Rally?

As ther world waits with bated breath for Janet Yellen"s statement this afternoon - whiche is uniformly expected to be a nothing-burger, some are wondering if the recent flip-floppery by Yellen, Draghi (and even Kuroda with his "actual" tapering while lowering inflation expectations) does not leave today open to another modst shift back in The Fed"s "hawkishness". As Bloomberg"s macro strategist warns, this sets the market up for a surprise and as he warns: "Dollar risks are starting to seem skewed all one way: toward an immediate rally."

There’s extremely bearish positioning, that’s failed to adapt to changing circumstances, into event risk that’s structured to surprise in the opposite direction. That’s an explosive mix.

When something seems so obvious, your immediate instinct should be to ask, "what’s the catch?" My problem is that this time, I just can’t see one.

The dollar is poised like a coiled spring against so many other currencies. Some of them have started to retrace on their own -- AUD, JPY and KRW as some examples -- but the FOMC can trigger all the rest at once today.

Investors have suddenly become inordinately focused on disappointing inflation data from the U.S. Inflation prospects have looked subdued for months so it seems completely irrational to expect the FOMC to use a meeting with no press conference to now significantly alter their guidance.

The committee is attempting to normalize policy as a strong labor market and roaring financial assets give it a window to act, not because of runaway inflation.

Exceptionally easy financial conditions show policy makers still have room.

It’s completely fair to argue that they may start fearing deflation again at some point. But this isn’t the meeting that they’ll choose to radically shift the official stance.

And that stance is still that 2017 will see both the beginning of balance sheet reduction as well as another rate hike. Again, that won’t change today.

If anything, the risk is that they give an exact start date for balance sheet tapering and it’s sooner than the market expects. Bloomberg Intelligence notes that an operational advantage of announcing a timeframe this week is that it would allow the Treasury to lay out its intended response in the quarterly refunding statement due Aug. 2.

The market is complacently short dollars as we enter the height of summer illiquidity. That’s despite yields jumping higher on Tuesday, with U.S. terms-of-trade that have been improving all year, and with other major central banks -- the ECB, BOJ and RBA -- emphasizing their dovish credentials.

A dollar rally can be short but violent. The conditions and the catalyst are both primed and ready.

Does Cudmore have high conviction? His answer is clear..

Yes. For a reason.

What’s the alternative? The FOMC sounds slightly more dovish? So what. The market’s already very short dollars. It won’t be inclined to add aggressively to that going into August.

As I wrote on Monday, politics are a red herring and financial assets rarely move in a straight line. Beware the dollar jack-in-the-box.

He may be right - given the extreme "short" dollar positioning (dovish) and what is now a record short speculative position in 2Y Treasury Futures (hawkish)...

The market hopes that Yellen doesn"t misstep.

Goldman Is Troubled By The Fed's Growing Warnings About High Asset Prices

With both the S&P, and global stock markets, closing last week at new all time highs, it is safe to say that any and all warnings about "froth", and perhaps a bubble in the market, as Deutsche Bank characterized it last week have been ignored. And yet, as Goldman"s economist team writes over the weekend, the recent rise in warnings about "risk levels" and asset prices by Fed officials is concerning: "Fed officials have expressed greater concern about asset prices and financial stability risk recently, a change from their more relaxed view last fall. In particular, the minutes to the June FOMC meeting highlighted concern about high equity valuations and low volatility and drew a connection between potential overheating in the real economy and financial markets."

To underscore this point, here is a recap of recent Fed warnings about asset prices, which have increased significantly since the presidential election:

Janet Yellen, July 12, 2017

So in looking at asset prices and valuations, we try not to opine on whether they are correct or not correct. But as you asked what the potential spillovers or impacts on financial stability could be of asset price revaluations — my assessment of that is that as assets prices have moved up, we have not seen a substantial increase in borrowing based on those asset price movements. We have a financial system and banking system that is well capitalized and strong and I believe it is resilient.

FOMC Minutes, July 5, 2017

...in the assessment of a few participants equity prices were high when judged against standard valuation measures...  Some participants suggested that increased risk tolerance among investors might be
contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability... Several participants expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability or could lead to a sharp rise in inflation that would require a rapid policy tightening that, in turn, could raise the risk of an economic downturn.

Janet Yellen, June 27, 2017

Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn"t try to comment on appropriate valuations, and those ratios out to depend on long-term interest rates.

John Williams, June 27, 2017

The stock market seems to be running pretty much on fumes... so something that clearly is a risk to the U S economy, some correction there, is something that we have to be prepared for and to respond to if it does happen. The U S economy still is doing — I think on fundamentals — is doing quite well. So I"m not worried about some kind of late- "90s, dot-corn bubble economy where a lot of the underpinnings were driven by the stock market.

Bill Dudley, June 23, 2017

Monetary policymakers need to take the evolution of financial conditions into consideration... For example. when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened. On the other hand, when financial conditions ease - as has been the case recently - this can provide additional impetus for the decision to continue to remove monetary policy accommodation.

Stanley Fischer, June 20, 2017

House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.

Janet Yellen, June 14, 2017

We"re not targeting financial conditions. We"re trying to set a path of the federal funds rate, but taking account of those factors and others that don"t show up in a financial conditions index.

Robert Kaplan, June 30, 2017

That"s not to say these imbalances won"t build and I am concerned that they may but if you ask me today I think right now it"s manageable, but I do think if there were some correction also in the markets. that could actually be a healthy thing.

Neel Kashkari, May 17, 2017

Monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large.

Eric Rosengren, May 8, 2017

While I am certainly not expecting such a scenario to occur, central bankers are charged with thinking about adverse risks to the economy. So current valuations in real estate are one such risk that I will continue to watch carefully.

Jerome Powell, January 7, 2017

With inflation under control. overheating has shown up in the form of financial excess. The current extended period of very low nominal rates calls for a high degree of vigilance against the buildup of risks to the stability of the financial system.

Perhaps their concern is due to the following Citi chart which we have discussed on numerous occasions, and which shows the "incredible" correlation between global central bank balance sheet size and market returns in recent years.

Or perhaps the Fed is not worried about stock prices at all, and while the recent commentary about asset valuations is notable, what the Fed is really concerned about is the recent pick up in the unemployment rate, something which as Bank of America noted last week, "there are no episodes in which unemployment rose a bit and remained stable at its natural employment rate. Rather, a recession has always followed."

Whatever the reason for this unexpected shift in rhetoric, here are some additional summary observations from Goldman, which while pointing out that such comments by Fed members are quite unorthodox, "Fed officials do appear more concerned about financial stability risks, and this could strengthen the case somewhat for tightening in the future."

• Traditionally, Fed officials have thought it wisest to respond to financial variables through their forecasted impact on inflation and employment. They have taken a more skeptical view of using the funds rate to lean against stretched valuations, though they have not closed that door entirely.


• We find that the Fed has largely followed these principles in practice, responding primarily not to valuation levels but rather to something like our FCI growth impulse, an estimate of the impact of recent changes in financial conditions on the growth outlook. Currently, the FCI growth impulse points to a healthy boost over the coming year, strengthening the case for further tightening.


• Leaving financial instability concerns out of the reaction function does not mean the policy stance has no role in reducing these risks. Our cross-country model of asset price busts shows that bust risk is substantially higher when the output gap is more positive, supporting the concern noted in the June minutes. This suggests that if the Fed is successful in containing overheating in the real economy, it can breathe at least a little easier about bubble risk.


• To what degree might the FOMC view financial stability risk as an independent argument for higher rates? Research by Fed economists suggests that because credit growth has been only moderate, the optimal response of the funds rate to financial instability risk is very small. But this could cut both ways: the economy’s reduced dependence on debt relative to the last two cycles also implies less risk that moderate tightening will lead to a crash.


• At this point, the FOMC does not need additional reasons for gradual further tightening, which a traditional reaction function based on the dual mandate suggests is already warranted. But Fed officials do appear more concerned about financial stability risks, and this could strengthen the case somewhat for tightening in the future.

The quandary would be promptly resolved, of course, if in the ongoing increasingly nebulous relationship between the Fed"s policy intentions and record high stock prices, which as Kevin Muir summarized simply as "stocks dare the Fed", and are "about to make Dudley, Fischer and Yellen extremely nervous", the Fed were to defy markets and unexpectedly hike rates once again, responding to the "dare", and making it clear that the Fed is indeed focused first and foremost to threats to financial stability resulting from market "froth" and "bubbles"... which incidentally it itself has created.

"The Tide Is Going Out" - JPMorgan's Dimon Warns QE Unwind Could Be Far Worse Than Fed Hopes

Janet Yellen confidently stated at the last FOMC press conference that The Fed will start unwinding its massive balance sheet "relatively soon" and Patrick Harker, the Philadelphia Fed president, has said the process will be so dull that it is equivalent to watching paint dry.

Not everyone agrees...

Louis Crandall, an economist at Wrightson Icap, said at the time:

"When they [the Fed] launched QE, they were confident about the direction of the impact but cautious about projecting the precise magnitude. They should be even more cautious about estimating the impact of unwinding the portfolio, as they have even less control over the outcome."

The unwind will be lumpy for sure...

And today, none other than JPMorgan CEO Jamie Dimon poured some more cold water on The Fed"s complacency at this "storm in a teacup". Speaking at a conference in Paris this morning, Bloomberg reports that Dimon warned...

“We’ve never have had QE like this before, we’ve never had unwinding like this before."

“Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

“When [the unwind] happens of size or substance, it could be a little more disruptive than people think."

“We act like we know exactly how it’s going to happen and we don’t.”

Central banks would like to provide certainty but “you cannot make things certain that are uncertain,” Dimon said. All the main buyers of sovereign debt over the last 10 years -- financial institutions, central banks, foreign exchange managers -- will become net sellers now, Dimon said. Investors are listening closely to policy makers to determine when and how central banks will start reducing their balance sheets. A global bond rout spilled over into equities last week on signs that central banks are taking a more aggressive stance.

“That is a very different world you have to operate in, that’s a big change in the tide,” he said. “The tide is going out.”

Will "the tide is going out" be the "the music stopped playing" quote of this collapse?

Hedge Fund CIO: "Normally The Fed Would End This Bubble, But It Can't This Time For One Reason"

In his latest weekend notes, One River Asset Management CIO, Eric Peters, picks up where BofA"s Mike Hartnett left off on Friday when he said that the "QE Monster" will only end when "the Wall Street bubble" finally shocks the Fed. Yes, but what will "end it", or better yet, what will "shock" Yellen and company out of their complacency?

To this, Peters" response is that the Fed finds itself in a big "quandary" not so much due to the S&P500, and overall asset levels, which even Yellen now admits "pose risks to financial stability" as per the latest FOMC Minutes, but due to China:

“The real credit excesses haven’t been created here, they’ve formed in China, which leaves the Fed in a quandary.” Much as the Fed would like to have jurisdiction over every corner of global finance, they no longer control China.

He"s right: with rates on various Chinese debt instruments surging in recent months, as Beijing cracks down on shadow banking, any further tightening by the Fed may or may not impact the momentum-chasers that have sent Amazon above $1,000, but it will certainly have a dramatic impact on China"s cost of funding, which in turn would unleash the next deflationary shockwave around the globe, sending global rates tumbling once again as the reflationary, rate hike frenzy fizzles, and forces the Fed to promptly cut rates back to zero (if not negative).

Here is the quick and dirty from Eric Peters:

Quandary

“Classic late-cycle action,” said the CIO. “Vol-compression, loosening financial conditions, and a pain-trade that tilts forever higher,” he continued. “Normally the Fed ends it. Hiking aggressively, flattening the curve, widening credit spreads, and then the economy rolls.”

But this cycle is not quite like the others.

“The real credit excesses haven’t been created here, they’ve formed in China, which leaves the Fed in a quandary.”

Much as the Fed would like to have jurisdiction over every corner of global finance, they no longer control China. 

“By closing the capital account, the Chinese once again have complete dominion over their domestic credit machine,” continued the same CIO. “When they were actively opening up the capital account, China relinquished control over their interest rates to the Fed.” The volatility of Jan/Feb 2016 was one of many consequences; a lesson not soon forgotten.

Now that the Chinese have retaken control, economic volatility is more likely to come from within. “The warning sign for real problems will be a material decline in house price appreciation.”

Or, as we explained in March, "Why The Fate Of The World Economy Is In The Hands Of China"s Housing Bubble"

Here Is The Latest Breakdown Of Fed Hawks And Doves

Ahead of today"s FOMC minutes, UBS reminds us that there has been substantial turnover on the FOMC, and so the Swiss bank has updated its periodic commentary on FOMC participants, as well as its popular "hawk-dove" chart.

While many of the actors are well-known, there are some unknowns and unfamiliar faces, with more to come. The biggest unknowns are Raphael Bostic, the brand new President in Atlanta and how the Richmond Fed will factor into the debate after Jeffrey Lacker"s departure. In addition, with three vacancies on the Board and Chair Yellen and Vice Chair Fischer"s terms ending early next year, there will be considerable turnover.

Here is the full breakdown of the Fed"s latest "nest", from UBS" Seth Carpenter.

The new scale

First, Raphael Bostic, the new president of the Federal Reserve Bank of Atlanta has not established a track record to judge. That said, Bostic is a very smart, well-trained economist, who is comfortable mixing theory and empirical work, so a good guess is that he will not initially be at either extreme. Also uncertain is the role of the Federal Reserve Bank of Richmond. Jeff Lacker resigned after acknowledging leaking FOMC information in 2012. The first Vice President of the Bank gets to take his place, but it is hard to know how that will play out. Richmond is not a voting member this year, so the distinction is slightly less critical.

Among the hawks on our scale, the easiest calls are Esther George (FRB-Kansas City) and Patrick Harker (FRB-Philadelphia). Both have been consistently hawkish in tone. Loretta Mester (FRB-Cleveland) is a career Fed economist, having worked for Charlie Plosser (a noted hawk) at the Philadelphia Fed. She is less doctrinally hawkish than her old boss and takes a nuanced view of the data, although she usually interprets  them with something of a hawkish tilt. Eric Rosengren (FRB-Boston) has become hawkish in recent years, motivated less by inflation fears than by financial stability concerns. His policy prescriptions have become consistently to the hawkish side of the Committee.

We see a large set of centrists on the Committee, large enough to shade some participants to one side or the other.

• John Williams (FRB-San Francisco) and Stan Fischer (Board) are academic-minded economists  who have been slightly ahead of the Chair in calling for a removal of accommodation. They share a standard macroeconomic framework for policy with the Chair, so the difference is one of degree rather than kind.


• Rob Kaplan (FRB-Dallas) is a relative newcomer who has not staked out positions that are particularly out of the mainstream.


• Chair Yellen should rightfully be seen as the center of the Committee. Bill Dudley (FRB-New York) is ex-officio Vice Chair of the FOMC. In practice, the Chair and the Vice Chair along with the Vice Chair of the Board plan policy strategy together, putting Dudley in the center, as well. Jay Powell (Board) has accumulated deep experience and expertise during his tenure on the Board. His views have become more fully articulated, but he has remained in the center.


• Charlie Evans (FRB-Chicago) is an academic-minded economist who had consistently stressed the undershooting of the inflation target and a lack of fear of a symmetric overshooting. This stance earned him a reputation as an extreme dove, but in the event, inflation ran below the FOMC"s target for several years; yet another example of the conflation of preferences with a policymaker"s economic outlook.


• Lael Brainard (Board) was an outspoken advocate last year for patience in removing accommodation, particularly in light of international developments. Her dovishness seems to come from a risk-management perspective.


• Neel Kashkari (FRB-Minneapolis) is another relatively recent addition to the FOMC. He initially seemed reluctant to stake out strong views on policy, but in the last several months has become an outspoken dove, dissenting against a rate hike.


• Jim Bullard (FRB-St. Louis) is hard to place on the continuum (a statement that we suspect he would approve). He has called for no more interest rate hikes for the foreseeable future, a position that seems to be at the extreme of dovishness. But, he sees the world as being in one of potentially many equilibria, and allows for the possibility that the equilibrium could shift requiring either a tightening in policy or potentially an easing in policy.

A final note on voting. We have separated voters from non-voters, as is customary. One should keep in mind, however, that in practice, all FOMC participants take part in the debate. The recording of the vote and number of dissents matters, but the FOMC has been run as a consensus-driven body for a long time, and the distinction between voter and non-voter is typically overstated.

And visually:

JPM Cuts 10Y Yield Forecasts "Significantly Lower" Due To Weaker Inflation Outlook

Just one day after Goldman reluctantly cut its 2017 year end forecast on the 10Y yield last Friday from 3.00% to 2.75%, "reflecting some added uncertainty on the US macro outlook" while conceded that "bond bears", i.e., those clients who have listened to it, "have had a difficult 2017" it was JPMorgan"s turn, and over the weekend JPM announced it was adjusting its US rate forecast "significantly lower", slashing its year end 10Y yield target to 2.75% from 3%, reflecting “a weaker outlook on core inflation and reduced expectations around tax reform and infrastructure spending.”

In the note by JPM"s Jay Barry, the bank also trimmed most other tenor forecasts by 15bp-35bp lower, saying that the inflation outlook “has changed markedly” over past month based on weakness in core CPI in March and April. JPM also said that  as for fiscal stimulus, odds are rising that it “gets pushed into FY18.”

And also just like Goldman, JPM tried to hedge adding that "even so, UST yields should rise in coming weeks,” because markets "continue to underprice the risk of further Fed tightening,” and yields “have consistently risen” ahead of FOMC meetings that include SEP and press conference; also, Treasuries “appear locally rich to other DM government bond markets.”

Finally, JPM maintains its recommendation to hold shorts in the 3-year sector and urges 10s30s flatteners, as the curve is ~3bp too steep adjusted for market’s medium-term Fed and inflation expectations.

Meanwhile, the fed funds market continues to be blissfully disconnected from the recent sharp slowdown in US economic data surprises, which as noted previously has posted one of the biggest drops on record, and if the disappointment persists, it is not impossible that the Fed will punts its June rate hike which the market now assumes is virtually assured.

FOMC Preview: Here Are The Possible Surprises In Today's Statement

Today"s FOMC announcement at 2:00pm is expected to be mostly a non-event, and the only incremental information will be what is contained in the updated statement, which comes one month ahead of the Fed"s next expected rate hike in June. There will be no press conference and no update to the summary of economic projections. The statement is expected to incorporate modest changes to reflect recent (mixed) data but see the risks around the meeting are low.

Here is what Wall Street consensus looks like ahead of 2pm:

• The market expect no rate hike at the May meeting; Fed Fund futures are currently pricing in a 65% probability of a June rate hike.


• There is a risk of a small hawkish surprise if the committee indicates they are "looking through" Q1 weakness in growth and inflation.


• A less likely dovish surprise could come from the FOMC emphasizing the decline in inflation.


• It is likely too soon for the committee to update language related to reinvesting balance sheet securities.


• Subsequent Fed speeches by Yellen, Fischer, Williams and Rosengren on Friday will likely provide additional color

Continuing the trend from recent weeks, most Wall Street firms expect the Fed to hike twice more this year despite the recent slowdown in US economic indicators and the near record collapse in the Citi eco surprise index, in June and September and announce balance sheet reduction in December.

With that in mind, below are some observations from Citigroup on the few surprises in the "wording" contained in today"s statement:

FOMC “looking through” weak Q1 may read slightly hawkish

The statement will need to update language regarding inflation, consumption, and job growth – all of which have slowed since the March meeting. The relative hawkishness depends on the extent to which Fed officials attribute the softness to transitory factors.

Consumer spending – Spending slowed significantly in January and February. The consensus view (reflected in March FOMC minutes) is that much of the weakness is transitory owing to (1) less utilities usage due to warm weather and (2) delayed tax refunds.

March: "Household spending has continued to rise moderately"

• Dovish: Household spending moderated.


• Neutral: Household spending moderated but consumer sentiment remains high and real income growth has been robust.


• Hawkish: Household spending moderated largely due to transitory factors

* * *

Inflation – A surprise decline in core prices in March led core PCE to print 1.6% year-on-year undoing most of the progress since 2016. Some update of the inflation language is in order.

March: "Inflation has increased in recent quarters, moving close to the Committee’s 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent."

• Dovish: Inflation is running below the committee’s longer term objective


• Neutral: Inflation has edged lower


• Hawkish: Inflation edged lower in part due to large declines in certain categories.

* * *

Labor market – Going into the March FOMC meeting the economy had added over 200k jobs in each of the previous two months. The last job print of 98K was widely attributed to payback from previously warm weather.

March: "Job gains remained solid and the unemployment rate was little changed in recent months."

• Neutral: Job gains slowed but the unemployment rate fell further.


• Hawkish: Job gains were solid over the last quarter and the unemployment rate fell further.

* * *

Balance Sheet – Discussion of the timing and details of tapering of reinvestments will likely continue at the May meeting. Assuming tapering is announced in December, the committee may wait until at least June and more likely September before adjusting language in the statement regarding the balance sheet. The minutes to be released on May 24 will likely be more informative on this point.

* * *

And here is Goldman"s full list of exepctations for today"s statement:

1. Constructive comments on full-year growth. Despite the 0.7% increase reported in this morning’s Q1 GDP report, we expect the FOMC statement will continue to sound constructive on growth trends, repeating that “economic activity has been expanding at a moderate pace”, or simply saying that activity “continued to expand.” Underlying growth in the first quarter appears firmer than headline GDP would suggest, and Fed officials including Vice Chair Fischer have argued that growth is likely to be stronger during the remainder of the year. Exhibit 1 summarizes this mixed but generally positive message from growth indicators, which featured some sequential slowing in payrolls growth and our Current Activity Indicator (CAI) but also a drop in the U3 and U6 unemployment rates as well as positive data surprises on net. Relatedly, we expect an adjustment to the statement’s labor market characterization that acknowledges the pronounced drop in the unemployment rate, yet also softens the language around “solid” recent job gains (reflecting the slowdown in March headline payroll growth). We also expect the committee to downgrade its assessment of household spending (from “rise moderately” to “rise modestly”) and for the committee to remove the word “somewhat” in its characterization of firming business investment (i.e. “business investment appears to have firmed.”)

2. Few changes to description of inflation-related data. The previous statement distinguished between headline- and core inflation, a distinction we expect the committee will retain. However, given the pronounced softness in the March core inflation report, the previous statement’s “little changed” characterization of core inflation would seem out of place. Indeed, this morning"s GDP report was consistent with core PCE inflation at 1.6% in March (yoy), down from 1.7% in February. Accordingly, we expect a brief acknowledgement of this softness (i.e. “core inflation slowed somewhat in March”). However, we expect the statement will retain the “continued to run somewhat below 2 percent” wording. Also, the mid-April drop in market-based measures of inflation expectations largely reversed in the final week of the month, with 5Y/5Y breakeven inflation now back at the March levels (2.1%). As a result, we expect no changes to the inflation expectations wording.

3. And unchanged inflation outlook. Despite the March setback, the drop in the March unemployment rate coupled with the committee’s apparent growth optimism suggest little need to modify the inflation outlook. We currently forecast core PCE inflation to reach 2.0% in early 2018, which seems broadly consistent with the March statement’s expectation that “inflation will stabilize around 2 percent over the medium term.” Accordingly, we expect no changes to the inflation outlook paragraph.

4. Unchanged balance of risks and “accommodative” policy description. At its June 2016 meeting, after concerns about the spillovers from Brexit had faded, the FOMC said in its statement: “Near-term risks to the economic outlook have diminished.” The committee upgraded this language again at the September meeting, saying: “Near-term risks to the economic outlook appear roughly balanced.” The qualifiers “near-term” and “roughly” suggest Fed officials are less than fully confident about the outlook. However, we do not expect any changes to this section of the statement, as improving international growth trends are likely weighed against continued geopolitical risks and today’s softer 1Q GDP data. A meaningful upgrade to the balance of risks should be taken as a hawkish signal for the near-term policy outlook, in our view. In terms of the assessment of the stance of current policy, committee members appear to use “accommodative” interchangeably with “modestly” or “moderately accommodative,” and we see little reason to qualify the “accommodative” characterization in next week’s statement – particularly because doing so would likely be interpreted as a dovish shift. 

5. Subtle reference to eventual balance sheet adjustment. We expect a minor change to the balance sheet paragraph, with some sort of allusion to possible eventual reductions. Given the extent of the discussion in the minutes to the March FOMC meeting – as well as several comments by Fed officials over the last month about the Fed’s plans for ending reinvestment – it would seem odd for the statement to omit any reference to the topic. At the same time, committee members will likely want to avoid signaling an imminent policy change. If the committee does edit this section, we expect the wording to be fairly vague and noncommittal. One possibility is that the committee adopts the “gradual and predictable” language from the March minutes as a description of its overarching balance sheet policy. 

6. No explicit mention of fiscal policy. Notwithstanding the Wednesday tax announcement, the committee has gained little incremental clarity on the legislative outlook since the March meeting. Furthermore, the FOMC does not explicitly include the issue in the list of factors it will use to assess appropriate monetary policy (even though fiscal stimulus may be the single most important source of uncertainty for the economic outlook this year and next year.) The committee has mentioned fiscal policy in past statements, but only after-the-fact in recent years. For example, statements in 2009 referred to “fiscal and monetary stimulus”, while those in 2013 said that “fiscal policy is restraining economic growth”. A similar approach seems likely this time around, with fiscal policy only discussed in the statement after legislation begins to affect the economy. 

7. No dissents. Minneapolis Fed President Neel Kashkari dissented against the March hike, but dovish dissents seem very unlikely given our expectation that rates will be left unchanged. We also do not expect any hawkish dissents, in part because a pause at this meeting would still be consistent with as many as four hikes over the course of 2017 that could be achieved in the three remaining press conference meetings.

Did The Fed Just Hint At Monster Inflation?

We won’t bore you with yet another article about the recent rate hike by the Federal Reserve. This move was widely expected, as the Fed members had been hinting this would happen for several months now. Additionally, the new ‘hints’ about an additional two rate hikes later this year also didn’t surprise the market as we believe this was already priced in. The slight hike in the Federal Funds Rate estimate for 2019 to 3% (from 2.9%) didn’t see to worry the markets as the indices were all sent higher on the back of the FOMC meeting.

The ‘dot plot’ also caught our attention. Even though Yellen specifically announced the Fed was aiming for at least three rate hikes, the dot plot chart shows there are three members who are still expecting a maximum of two rate hikes. Surprising, considering the most recent interest rate decision was almost unanimous.

Source: Bloomberg

It made us scratch our heads as there didn’t seem to be any logical explanation at all, but then the Royal Bank of Canada came up with a theory which makes a lot of sense. Fed member Lockhart (Fed Atlanta- resigned at the end of February and could not possibly have submitted a new rate hike expectation. According to RBC, this could mean his (temporary?) replacement just submitted the same position as the previous time the Fed Atlanta was indicating, before Bostic was appointed as the new President and CEO of Fed Atlanta.

A logical explanation, but this wasn’t the only ‘interesting’ thing after the FOMC meeting. In the very first paragraph after officially announcing the rate hike, we could read this:

“ The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.”

The logical explanation here would be the interpretation the Fed wouldn’t allow the inflation rate to run at a higher percentage than 2% for a prolonged period of time, but the statement could also be read as the Fed explicity warning of a much higher inflation rate than originally anticipated. We know the market has always been prone to overshooting, either on the positive or negative side of the equation. We don’t think we have ever heard the Fed talk about ‘symmetric’ inflation, but as the FOMC members are leaking more intel than the Exson Valdez spilled oil, this position will undoubtedly be clarified in a ‘coincidental’ interview or public speech.

Source: Federal Reserve

Looking at the expectations of the Fed board members, they are practically still confirming ‘money’ is losing its value pretty fast. Whilst the median expected inflation rate is pretty close to 2%, an additional two-step rate hike would still put the ‘real’ interest rate below zero. And that’s what counts; your money is worth less day after day.

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"This Is Not The Reaction The Fed Wanted": Goldman Warns Yellen Has Lost Control Of The Market

With stocks soaring briskly around the globe following Yellen"s "dovish" hike, and futures set for a sharply higher open with the Nasdaq approaching 6,000, something surprising caught our attention: in a note by Goldman"s Jan Hatzius, the chief economist warns that the market is overinterpreting the Fed"s statement, and Yellen"s presser, and cautions that it was not meant to be the "dovish surprise" the market took it to be.

Specifically, he says that while the FOMC delivered the expected 25bp hike, with only minor changes to its projections. "surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices."

Even more surprisng is that according to Goldman, its financial conditions index, "eased sharply, by the equivalent of almost one full cut in the federal funds rate."

In other words, the Fed"s 0.25% rate hike had the same effect as a 0.25% race cut!

The implication from the market"s reaction is that at current levels, financial conditions are poised to make a substantial positive contribution to growth in 2017, from a starting point of essentially full employment, inflation close to the target, and a sub-1% funds rate; which in light of concerns about an economic overheating due to Trump"s fiscal policies is precisely the opposite of what Yellen wants. Hatzius warns that "the FOMC will lean against this, and will deliver more monetary tightening than discounted in the bond market."

It gets better: Goldman"s chief economist - like virtually all other carbon-based market participants - admits he was stunned by the market reaction to the Fed rate hike. While Hatzius agrees that the general direction of the market response makes sense, "the magnitude greatly surprised us" and adds that Wednesday"s price action was scored by Goldman"s models "as the third-biggest dovish surprise at an FOMC meeting since 2000, at least outside the financial crisis."

And the punchline: when asked rhetoricall if "the FOMC was aiming for this outcome?", Hatzius says "No, almost certainly not."

The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.

In other words, whether on purpose or otherwise, according to Goldman the Fed, which now wants to tighten financial conditions (i.e., see asset prices lower) not only achieved the opposite, but has now lost control of the market.

So "how will the committee respond to this potentially undesired move?"

At the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.

Our modal forecast remains for a total of three hikes this year, with remaining moves at the meetings in June and September, followed by four hikes each in 2018 and 2019. We see a 60% subjective probability that the next hike occurs at the June 2017 meeting, 10% for July, and 20% for September. We also expect an announcement of gradual balance sheet rundown in December; if this does not occur, the likelihood of a fourth 2017 hike would increase.

Of course, if the first of two, three or four rate hikes in 2017 is any indication, the market, already sloshing in trillions of excess liquidity, will simply take the Fed"s next tightening as an indicator of easing, and send risk assets to even more obscene highs.

* * *

Here is the full Q&A from Hatzius on why following the Fed"s 3rd rate hike in a decade, "Financial Conditions Move in the Wrong Direction":

Q: What surprised you at today’s FOMC meeting?

A: There were certainly a few dovish surprises, relative to both our expectations and our read of the consensus. First, none of the FOMC participants who projected three hikes or less for 2017 in December seems to have moved to four hikes or more; we expected two participants to move up, and some forecasters had even projected an increase in the median to four hikes. Second, the Fed’s estimate of the structural unemployment rate declined by a tenth to 4.7%; this coincides with our own estimate, but we didn’t expect the committee to make this move today. Third, we did not expect Minneapolis Fed President Kashkari to dissent in favor of unchanged rates, and we don’t think others did either. Fourth, the explicit statement that the inflation target is symmetric also came as a surprise, to us and likely others. And fifth, the statement was modified to say that the committee looks for a “sustained” return to 2% inflation.

Q: So was it a big dovish surprise overall?

A: It didn’t seem like it to us. First, the surprise in the dots, while real, seemed fairly small compared with past SEP meetings, with no changes in the median number of hikes in 2017 and 2018 or the median long-term funds rate. Second, the structural unemployment estimate moved only 0.1 point, has been trending down for several years, and is still above the committee’s forecast for the actual rate. Third, the predictive power of dissents from regional Fed presidents—especially dissents against a move that the committee is making, as opposed to dissents in favor of a move the committee has not yet made—is limited. Fourth, Fed officials have often noted that their inflation target is symmetric; moreover, the move seemed to be “defensive” in nature, as Chair Yellen noted in the press conference that it was designed to take the sting out of the recognition that there is no longer a sizable “current shortfall” in inflation. And fifth, the word “sustained” may have been equally defensive in nature, clarifying that a temporary rise in (headline) inflation to 2% or more is not, on its own, sufficient to meet the committee’s goal.

Moreover, there were also a few slight hawkish surprises. First, in the press conference, Chair Yellen declined the invitation to give much meaning to the word “gradual”; in fact, she noted that “…rates were raised at every meeting starting in mid-2004, and I think people thought that was a gradual pace, measured pace…” although she hastened to add that the committee is not envisaging “anything like that.” Second, the median pace of hikes in 2019 rose to 3½ from 3. These are minor, but they illustrate that not all the news was dovish.

Q: So what do you make of today’s market response?

A: The direction makes sense, but the magnitude greatly surprised us. As shown in Exhibit 1, our factor model for discerning monetary policy surprises from the co-movement of different asset prices scored today"s price action as the third-biggest dovish surprise at an FOMC meeting since 2000, at least outside the financial crisis. (The only two non-crisis meetings that were clearly bigger were the August 2011 move to calendar guidance and the September 2013 decision not to taper QE; the March 2015 and March 2016 cuts in the dots were similar to today’s move.) And as shown in Exhibit 2, our FCI eased by an estimated 14bp on the day—about 2.3 standard deviations and the equivalent of almost one full cut in the funds rate—and is now considerably easier than in early December, despite two funds rate hikes in the meantime. Our interpretation is that markets must have been positioned for much more hawkish news than we had thought.

Exhibit 1: According to Our Factor Model, This Was a Large Dovish Surprise

Exhibit 2: Our FCI Has Reversed Most of the Recent Tightening

Q: Do you think the FOMC was aiming for this outcome?

A: No, almost certainly not. The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.

Q: How will the committee respond to this potentially undesired move?

A: At the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.

Q: So what do you expect from the Fed for the rest of 2017?

A: Our modal forecast remains for a total of three hikes this year, with remaining moves at the meetings in June and September, followed by four hikes each in 2018 and 2019. We see a 60% subjective probability that the next hike occurs at the June 2017 meeting, 10% for July, and 20% for September. We also expect an announcement of gradual balance sheet rundown in December; if this does not occur, the likelihood of a fourth 2017 hike would increase. At the margin, today’s FCI move has increased our conviction that the committee will need to deliver more tightening than priced in the markets at this point.

RBC: "The Fed Is Now Forced To Walk Back The Market's Incorrect Dovish Interpretation"

First, it was Goldman"s chief economist Jan Hatzius, who in a fascinating note explained why the market has totally misread the Fed"s tightening intentions, claiming the market surge is "not the reaction the Fed wanted", alleging that the market"s dramatic "easing" response was "not the outcome the FOMC aimed for" and concluding that "at the margin, it will likely make them more inclined to tighten policy", a polite way of saying that the Fed may now not be behind the inflationary curve, but that it is certainly behind when it comes to "explaining" to the market that it has run ahead of itself.

Now, in a follow up note, RBC"s head of cross-asset strategy makes the exact same point as Goldman, and warns that "the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher."

And since Goldman still has a direct hotline, both literal and symbolic, to former Goldman employee Bill Dudley who is in charge of the NY Fed, it would not be surprising if during the Fed"s next public appearance, an FOMC member makes it very clear that having both of its core original mandates, inflation and emloyment, supposedly under control, it is now taking on the 3rd one - preemptive market stability, by making sure that risk assets are halted in their bubbly tracks.

Below are the key excerpts from today"s note by RBC"s Charlie McElliggott:

FED CREATES MORE ROPE TO HANG THEMSELVES WITH

#HOTTAKES:

• Despite hiking, the Fed missed a major opportunity to play “catch-up” without disrupting the market—as price-action showed that investors were clearly prepared for ‘hawkish’ outcomes.


• Instead, the FOMC / Yellen’s commentary (in light of the above ‘hawkish positioning’ dynamic) actually created EASIER / LOOSER financial conditions, with real rates collapsing lower on the session.  This will make the eventual exit-process that much more difficult—thus, “more rope to hang themselves with.”


• With Yellen noting that the Fed intended to keep its policy accommodative for “some time”—in conjunction with the overly simplistic market take on the lack of movement in the average dot (FAR more nuanced than that) and the ‘hawkish’ buy-side positioning--the Fed also created significant (under)performance frustration across many strategies yesterday, with the exception of a 2 standard deviation ‘+++’ day for many risk-parity portfolios (which essentially run ‘short convexity’ long only cross-asset books, which are now likely to be in-process of ‘levering-up’ off of the ‘vol crush’).


• For the above reasons, I believe the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher.

COMMENTARY:

So the Fed hiked….and nominal rates gapped lower, breakevens traded higher, real rates collapsed, and financial conditions LOOSENED.  Why?  To me, the moves were largely positioning-related, being caught wrong-footed inherently with regards to ‘expectations.’  I do not believe the Fed intended this to be a dovish message, and they are going to have to clarify this to the market in coming weeks, in turn risking / creating more volatility.  There is a fixed-income short / ED$ steepener to be laid-back-out soon. 

To sum up the ‘by-and-large’ client reaction to yesterday’s post-Fed response (with a touch of relief from the Dutch election sprinkled-in) on a scale of 1 to 10, I’d say the buy-side gave it a “MEHHH.”  Optically and absolutely, yesterday WAS of course a day of positive performance for many funds long risky assets, considering SPX +20 handles, EEM +2.6% (+2 SD move), IWM +1.6% (+2 SD move), HYG +1.4% (+3 SD move), LQD +0.9% (+2.6 SD move) et cetera. 

Instead though, it felt ‘empty’ or like a missed performance opportunity for many, because despite your longs doing ‘okay,’ many of your shorts were up just as much, if-not-more.  And regarding the longs, the stuff that did ‘really well’ yesterday is generally underweighted OR in many cases, has recently been pared-back (i.e. cyclical beta equities).  Case-in-point, look at this example within the equities space:

• HF VIP Longs + 0.7% against HF VIP Shorts +0.7%


• High HF Concentration +0.9% against Low HF Concentration +1.0%


• MF Overweights +0.6% against MF Underweights +1.0%

Ugh.

This was an interesting rally because it looked like the old “QE”- varietal, where the interpretation of anything ‘dovish’ (in this case ironically it was a dovish HIKE via a simplified read basically that "unch on median / average dot" countered the recently hawkish momentum / rhetoric / data) actually sent UST"s sharply higher (TY largest ‘up’ day since June ’16) / rates sharply lower / USD sharply lower (BBDXY a -3 SD move lower and largest ‘down’ day since July ’16).  Real rates lower = easier financial conditions = Risk-on, Vol smoked = ‘short convexity’ vol trigger strategies likely driving mechanical re-levering.

The real news to me in the Fed message was two-fold:

• First, the dot shift was beautifully spotted by Mark Orlsey and Tom Porcelli going-into the event.  Looking at the simple scale of the absolute move in the average- or median- dot simply doesn’t ‘cut it’ in the case of “what is to come”—it is far more nuanced.  As such, the takeaway I think the market has initially-missed was the fact that the marginal dot ‘shift higher’ came from the bottom of the plot—i.e. IT WAS THE MOST DOVISH FED MEMBERS WHO UPPED THEIR DOTS.  This dynamic is going to have to be ‘trued-up’ in coming months considering the data trajectory (new 5 year highs in Bloomberg US Econ Surprise Index yday) and is likely to be a source of interest rate-driven cross-asset volatility.


• The second notable takeaway from yesterday was Yellen’s very modest backing-away from prior comments made from Fed officials regarding an absolute-level FF rate (1.00%) acting as a ‘trigger’ for cessation of reinvestments to shrink their balance sheet.  This is important bc again, Fed members have made this a point of focus going-forward, and their time-horizon window is shrinking now.  From a markets perspective within the mortgage space, losing the ‘buyer of last resort’ (into the daily Fed buybacks) will cause ripples, because if rates are going higher against you as a MBS trader—which is inherently a negatively convex product—you HAVE TO hedge by hitting TY.  This is a down-the-road discussion (now a 2018 story), but again will be a source of rate volatility in the future that could be ‘disorderly.’

Regardless of the medium- / long- term potentials…as such with the rates collapse lower on the day, duration sensitive equities were a large part of the equities leadership—e.g. defensives, divy yielders, low vol types like reits, utes, telcos (outside of energy sector with crude"s relief rally), while mega-allocations in tech, consumer discretionary and financials were, relatively speaking, "dead weight" and lagged index.  Of course too, the other leadership driver in stocks was the ‘reflation stuff’ that’s been ‘getting pitched’ over the past month like steels, metals & mining, oil services, E&Ps, high beta materials and industrials etc.  That stings for the majority of equity funds with regards to their current sector allocations, long ‘secular growth’ after reducing a fair bit of their "cyclical beta"‎ / value exposure in 1Q17. Much of yesterday’s leadership was curious ‘late cycle’ stuff, which o/p ‘early cycle’ by an astounding~140bps:

Obviously, the above dynamic is especially frustrating for many equity HF"s.   When you see the broad SPX tape + 0.8%, Russell 2k +1.6 and R3k‎ +0.9% but as a long / short you were only able to eek-out 40bps to 50bps simply due to you net long exposure, it stinks.  Even worse, mkt neutrals strats which simply don"t work in "gap higher" tapes. ‎

‎Bigger picture macro, the rates move spanked fixed-income shorts, while the Dollar crush crunched longs (especially against GBP, EUR and select EM).  Another “ouchy.”  And think about the initial "trump reflation" worldview themes from 4Q16 where it was Emerging Markets that was viewed as the "biggest loser"...and now is the "high flyer" (EEM +12.3% YTD) as the protectionist rhetoric is ‘walked-back’ (Navarro comments yday) and some thinking (benevolently) that US growth is soon to be the "higher water which will raise all boats."  Long EM over DM is now one of the most popular strategy calls going, FWIW.

But was yesterday really about US growth—was that really the case‎?  I"d say that in light of the recent ‘trend trades’ and positioning dynamics, a day where you see fixed-income, (long) duration-sensitives, defensives, low vol, late cycle and EM leadership ‘run higher,’ it speaks to folks looking to buy the "stuff that"s been left behind" in a classic “PM exposure grab” style, yelling to his trader "find me some cheap stuff!"  More "lottery ticket" mode than anything else, as evidenced by GDXJ (Jr Gold Miners ETF) finishing +11.5% higher on the day yesterday--a +3.1 SD-move. ALL OF THE LULZ.

As far as the current framework / narrative we’ve been operating under since midyear ’16, it shouldn"t be lost on anybody that this wasn"t a “higher growth = higher nominal rates = equities rally" which has obviously been the story of all global markets since secular lows for rates were put in last summer.  It was instead an ‘easier conditions,’ central bank driven rally of old QE-era.  As described above, this felt a lot more like “...greedy, not growth-y.”  

I think there"s an important message in there.

RBC US ECON TEAM SHOWS 2017 DOT SHIFT WAS ACTUALLY ‘HAWKISH’:

MARK ORSLEY SHOWS 2018 DOT SHIFT WAS ACTUALLY ‘HAWKISH’ / HIGHER AS WELL: