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

Betting Against A June Rate Hike? Something's Going On

We noted yesterday that the recent trend of increased volumes into Eurodollar future out-months was "odd"...

But the sudden surge in interest in Eurodollar calls (vs puts) suggests more than just a few prop bets are being placed on the fact that The Fed does not hike rates in June.

As Bloomberg notes, preliminary futures open interest data for Wednesday shows steep increases in several Jun17 eurodollar call strikes, consistent with view that Fed won"t hike in June amid tightening FRA/OIS spread. However, these options bets have largely gone unnoticed as futures-market-implied odds (which the majority of investors are shown) of a June hike have been steady at around 80% for a week.

A second consecutive drop in 3-month dollar Libor setting Wednesday prompted a flurry of dovish Fed bets and waves of buying across Jun17 eurodollar futures.

And furthermore, the Fed Fund Futures curve has flattened dramatically - signalling lost faith in The Fed"s hiking trajectory...

And while these bets are being placed - against a June rate hike, the LIBOR-OIS spread - traditionally a signal of bank credit risk, has collapsed back to historic norms.

One probable explanation for this is the gusher of bank funding availability that the world"s central banks (and even more so China) has unleashed. Nowhere is that more evident than in the total decoupling between "easing" financial conditions, and "tightening" monetary policy...

Despite two rate hikes, Goldman"s financial conditions index has improived to its "easiest" in 8 months - thanks to the world"s policy-makers fungible money spigot to keep the dream of reflation alive (as evidenced in the chart above by the S&P 500).

This means, according to Bloomberg"s Mark Cudmore, that The Fed’s room to tighten is being underappreciated.

The market adjustment, when it comes, will be felt more in the front end than the long end of the U.S. rates curve.

Rates markets are only pricing one-and-a-half more hikes in 2017. That seems reasonable in the blinkered context that inflation shows little sign of accelerating out of control. However, monetary policy analysis needs to be updated.

Amid an excess of global liquidity, inflation is being dominated by macro factors. Commodity prices and technological innovations, rather than marginal short-term interest rate adjustments, are top-most in people’s minds.

The last two Fed rate hikes had no sustained tightening impact. In fact, financial conditions in the U.S. are the loosest they have been in almost three years, and approaching the extreme of the historical range going back 27 years.

This suggests that the Fed has plenty of room to tighten policy. Why wouldn’t they take steps to normalize while they can get away with it?

Ignoring the fact that this yet again argues for a rethink of inflation targeting and using short-term interest rates as the primary policy tool, it’s important investors don’t misinterpret the rationale and implications of any tightening.

The next Fed moves won’t be driven by accelerating growth or runaway inflation, so the yield curve shouldn’t steepen. But a subsequently flatter yield curve shouldn’t be read as signifying a policy misstep.

This is just the way of the future. There is extremely abundant liquidity globally due to the expansion of central bank balance sheets. While that’s the case, old economic analysis frameworks are outdated and inadequate.

Which confirms what Morgan Stanley wrote,

Along with record high stocks, credit spreads at the tights since 2014, the broad dollar index continuing to hold little changed about 3% below the high hit in December, and longer-end yields remaining slightly lower year to date, historically low volatility across asset classes adds to a picture of very easy broad financial conditions. So does all the money in the short end helping keep CP yields and LIBOR lower as fed funds rate expectations have been moving up.

So the capitulation in pricing of a future reversal in the persistent LIBOR-OIS tightening trend in the past few months accelerated and had a large impact on swap spreads on top of more swapped issuance of corporate bonds by banks. The spot LIBOR-OIS spread fell another 0 7 by to 14 bp, another low since before the first Fed rate hike in 2015 after a 20 by drop in the past two months. That"s not far now from the 9bp average from 2004 through the first half of 2007 (before getting as high as 364bp on October 10. 2008. maybe the single most extreme financial market price of the whole crisis). The forward LIBOR-OIS spread to June fell to 14.8bp. down from 15.8bp Tuesday and 19.4bp Friday mostly giving up on any near-term widening. The LIBOR part of that was reflected in the Jun 17 eurodollar futures contract rallying 2bp to 1.265%, down from 1.305% Friday, even as Jul 17 fed funds futures held steady at 1.11%. pricing an 83% chance of a June rate hike, up from 1.095% Friday. Never mind seeing a transmission from the fed funds rate to broad financial conditions in impacts on stocks, long-end yields, the dollar. et al., if higher fed funds rate expectations struggle to even get traction in raising short-term market interest rates.

Which translated into english implies The Fed has lost control of the transmission mechanism of its operations, just as we noted Goldman concerned about, which brings up another question:

If the Fed retains its ability to steer financial conditions, why have financial conditions eased recently despite ongoing hikes? The answer is that Fed policy—especially Fed policy communicated around FOMC meetings—only accounts for a relatively small part of the ups and downs of financial conditions. And other developments such as the sharp pickup in global growth have been helpful for US financial conditions by boosting risk assets while keeping the US dollar from appreciating sharply in response to higher short-term interest rates. While it is difficult to say whether future non-monetary policy shocks will be positive or negative for US financial conditions, our finding that the impact of Fed policy on financial conditions remains (at least) similar to the longer-term average suggests that Fed officials should be able to achieve their goals for financial conditions by moving the funds rate if they try hard enough.

Fed Policy Retains Sizable Impact

What Goldman really meant to say is that the Fed"s 50 bps in rate hikes since December have been drowned and offset by the trillions in new credit created out of China. That credit expansion is now ending however, and China"s credit impulse has tumbled into negative territory (but that"s a different topic).

Going back to Goldman, Hatzius adds that "we find that the sensitivity of financial conditions to monetary policy shocks has been quite high recently, at least when we identify these shocks using bond market moves around FOMC meetings. This suggests that the easing of financial conditions is due to other factors, most obviously the improved global environment, not reduced traction of monetary policy."

What form will this monetary tightening "shock" take place? "

Our best (though uncertain) answer is that the committee will need to deliver 50-75bp more hikes per year than priced in the forwards to stabilize the economy at full employment. This is roughly consistent with our current funds rate call that we will see an average of 3-4 hikes per year through the end of 2019, compared with market pricing of just over 1 hike."

Of course, if Goldman is wrong and the Fed has no intention of sending risk assets into a tailspin with a monetary policy "shock", then there is no saying just how much further the combined effort of China"s gargantuan, if cooling, credit expansion, coupled with the "dovishly" hiking Fed can take stocks. However, by now it is becoming clear to even the most resentful permabulls - and even Goldman  - that the longer the Fed delays the day of reckoning out of pure fear of the unknown, the greater the chaos and loss in asset values when the Fed no longer has the luxury of picking when to pull the switch.

April Payrolls Preview: "It Better Be Good"

After the abysmal March labor report, all we - and the Fed - can say is that April better be good, or else Yellen"s claim of "transitory weakness" will simply be the latest nail in the coffin of Fed credibility. Here is the consensus for the key numbers the BLS will report at 8:30am ET on Friday morning.

• March Nonfarm Payrolls Exp. 185K, (Prey. 98K, Feb. 235K) US Unemployment Rate (Mar) M/M Exp. 4.6% (Prey. 4.5%, Feb. 4.7%)


• Average Hourly Earnings Exp. 0.30% (Prey. 0.20%, Feb. 0.20%)

Payrolls Expectation by Bank:

• Barclays: +225K,


• Bank of America: +170K,


• Goldman Sachs: +200K,


• SocGen: 165K,


• UBS: +210K,


• Wells Fargo:+178K,

Big Picture: Friday’s non-farm payrolls release follows Wednesday’s FOMC meeting where the Fed, as expected, kept rates on hold with all eyes now on June’s decision. One key takeaway from this week’s decision was the Fed noting the labour market conditions continuing to strengthen as growth slowed, as it deemed that job gains had been solid despite March’s softer than expected labor market report and quasi-recessionary Q1 GDP. The Fed’s statement was devoid of any real negatives and has led to Fed Fund futures pricing in a near 80% chance of a 25bps hike at its June meeting.

As RanSquawk notes, the expectation for a headline print of 185K points to a solid bounce-back from last month’s 98K, with the possibility of an upward revision to last month’s release as many analysts have attributed the weakness to negative payback following a late Easter holiday and an unusually warm winter in the US. However, the unemployment rate is expected to tick up to 4.6% from 4.5%, with many suggesting that last month’s fall was a result of sampling noise.

Goldman is even more optimistic than the consensus, and estimates payrolls increased by 200k in April, a sharp acceleration from March’s +98k pace and above the three-month moving average of +178k. It sees labor market fundamentals remaining encouraging on the whole, as April exhibited a further decline in initial jobless claims, improvement in regional service sector employment surveys, and an elevated labor market differential reported by the Conference Board. Continuing claims also fell sharply from survey week to survey week, dropping at their fastest pace in two years (-64k). Additionally, Goldman believes a favorable swing in the weather –reflecting mainly the timing of Winter Storm Stella during the March survey week – is likely to boost April job growth by roughly 25-40k relative to trend.

On the negative side, the bank believes the trend in retail employment growth is now slowing, reflecting the weaker brick-and-mortar sales trends and a continued shift towards less labor-intensive e-commerce firms. We also expect minor drags on job growth from the tail end of the federal hiring freeze and from a telecom strike that continued into the survey week (a -2k impact).

Goldman"s summary:

We estimate the unemployment rate remained stable at 4.5% in April following the one tenth drop in March (to 4.496% unrounded). The pace of employment growth picked up sharply in the household survey to start the year, with 1.4 million cumulative jobs added over the past three months (adjusted for the impact of the January population controls). Offsetting this improvement, the participation rate also moved higher, rising three tenths over the same period to 63.0%. While the risks to our unemployment rate forecast are likely skewed to the upside (given the possibility of mean-reversion), our base case expectation is that the rate continues to round to 4.5%.

Finally, we expect average hourly earnings to increase 0.3% month over month and 2.7% year over year, reflecting the interaction of firming wage growth with positive calendar effects. The April payroll period ended on the 15th, which in our model, is associated with above-average wage growth. Additionally, we believe the acceleration in the employment cost index to a cycle-high pace in Q1 provides additional evidence of firming underlying wage growth.

Recent Data: Wednesday’s ADP employment report showed another sign of steady growth, coming in at 177K vs. the expected
175K. Despite last month’s lack of correlation, the private employment figures tend to give an indication of the
headline figure when viewed over a longer horizon. April’s soft data (The Markit and ISM PMIs) point to a slowing in
hiring, although all the surveys’ employment sub-indices remained in expansionary territory, with all the headline
releases strong.

Factors arguing for a stronger report (per Goldman):

Weather rebound. We believe the winter storms in early March likely exerted a meaningful drag on payroll growth in the last report, as Winter Storm Stella hit the Midwest and East Coast at the beginning of the March survey week. The level of population-weighted snowfall during a March survey week was at its highest since at least 2005, and similarly, the month-to-month drop in April survey week snowfall is also the largest over that period. Accordingly, we expect April payrolls growth to benefit, as swings of this magnitude have historically been associated with meaningful acceleration in weather-sensitive payroll categories, such as construction, retail, and leisure and hospitality (Exhibit 1).

Exhibit 1: Weather Likely Shifting from a Drag on March Payroll Growth to a Boost in April

Source: National Centers for Environmental Information, National Oceanic and Atmospheric Administration, Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Regional granularity also suggests a meaningful drag from weather in the March employment report. Overall payroll growth in New England, Mid-Atlantic, and East North Central regions swung from +102k in February to -52k in March (compared to a 2016 average pace of +47k), likely reflecting unusually snowy March weather and some payback from the relatively warm February. Weather-sensitive industries in the regions contributed the majority of the March deceleration. One additional consideration is that the effects of Winter Storm Stella appear to have lingered throughout the March survey week in many populated areas. As a point of comparison, the snow produced by the January storms in the South – which did not appear to materially affect payrolls – had largely melted away by the Tuesday of that survey week. This suggests scope for the April employment report to benefit from workers in the establishment survey returning to their jobs. Taken together, our base case expectations assume that weather will boost April payrolls growth relative to the underlying trend by between 25k and 40k.

Jobless claims. Initial claims for unemployment insurance benefits declined, averaging 243k during the four weeks between the March and April payroll survey periods, a new cycle low. Additionally, continuing claims dropped by 65k from survey week to survey week, their largest decline over such a period since April 2015.

Service sector surveys. Despite declines in some of the service-sector employment surveys, our overall non-manufacturing employment tracker improved in April (to 54.5 from 53.7), and all of its components remained in expansionary territory. The ISM non-manufacturing (-0.2pt to 51.4), New York Fed (-5.2pt to +8.5, SA by GS), Dallas Fed (-3.6pt to +4.5), and Markit PMI Services employment components softened. However, this was more than offset by a sharp rise in the Philly Fed subindex (+9.2pt to +26.4) and further improvement in the Richmond Fed employment component (+4pt to +21). The key labor market subcomponent of the Consumer Confidence report also remained strong, edging down by 1.1 from the cycle-high reading in March to 11.7. Service sector payroll employment grew 61k in March and has increased 121k on average over the last six months.

Job cuts. Announced layoffs reported by Challenger, Gray & Christmas after our seasonal adjustment fell by 15k to 31k in April, a six-month low.

Arguing for a weaker report:

Continued retail weakness. Retail employment growth has fallen from its historical trend of 15-20k per month to -5k on average over the past six months. While some of the March weakness was likely weather-related, we expect the structural shift of retail sales from brick and mortar stores toward less labor-intensive e-commerce firms will continue to weigh on payroll growth in that industry, with the impact on the order of 10k per month relative to its previous trend. This drag on retail employment has appeared particularly pronounced recently – with a 61k cumulative drop in retail payrolls over the last two months – and we note the possibility that weak brick and mortar sales trends in Q1 may be accelerating the pace of this structural shift.

Exhibit 2: Shift Towards Online Retail Could Reduce Overall Job Growth by Roughly 10k per Month

Source: Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Federal hiring freeze. The administration’s hiring freeze for federal workers (excluding defense and public safety) went into effect on January 23 and concluded on April 11 – the Tuesday of the April survey week. So far, its impact appears quite limited, with federal payrolls down negligibly in February and March (mom sa). As shown in Exhibit 3, the impact also seems minor in the context of federal job growth during the 1981 federal hiring freeze at the start of the Reagan administration (Exhibit 3). Thus far, government departments may have been able to offset the hiring freeze through reduced attrition or increased contracted hiring. Accordingly, we expect a minimal drag from the final month of the freeze and are assuming a flat reading for total government payrolls in tomorrow’s report.

Exhibit 3: Federal Hiring Freeze Exerting Minimal Impact on Payrolls So Far

Source: Bureau of Labor Statistics, Goldman Sachs Global Investment Research

Telecom strike. The April employment report coincided with a strike of 2k workers in the wired telecom subindustry, which is set to reduce payroll growth in the information sector by 2k this month.

Neutral Factors:

Manufacturing sector surveys. Employment components of manufacturing sector surveys were mixed in April but all remained in expansion territory. The ISM manufacturing employment component fell 6.9 points to 52.0 after reaching its highest level since mid-2011 in the March report. The Richmond Fed (-15pt to +5) and Kansas City Fed (-4pt to +9) employment subindices also declined. In contrast, the Empire State (+5.1 to +13.9), Philly Fed (+2.4pt to +19.9), Dallas Fed (+0.1pt to +8.5) and Chicago PMI employment components all improved. Manufacturing payroll employment rose 11k in April, its fourth consecutive increase, and has increased 10k on average over the last six months.

ADP. The payroll processing firm ADP reported a 177k increase in private payroll employment in April – about as expected – suggesting a stable underlying pace of job growth. The ADP measure overshot considerably to the upside relative to BLS private payroll growth in March (+255k vs. +89k), making the task of teasing out the underlying signal from the report more difficult. We believe the 177k pace of private job gains was encouraging on the whole, and we also expect the rebound from Winter Storm Stella to show up more visibly in Friday’s employment report.

Job availability. The Conference Board’s Help Wanted Online (HWOL) report showed a modest decrease in April online job postings (-1%) following February’s uptick (+2%). However, we continue to place limited weight on this indicator at the moment, in light of research by Fed economists that suggests the HWOL ad count has been depressed by higher prices for online job ads.

Some other observations:

Fed Impact: The impact on the Fed’s thinking could be slightly more in focus following last month’s headline 98K. Despite the employment growth average still sitting well above the Fed’s threshold for moving towards full employment, another big miss could begin to throw up some questions for the central bank. At present the rate path and the Fed’s message remain clear, and as a result it would seemingly take a string of poor labour market reports to derail the Fed’s plans to deliver two more 25bps hikes this year.

There are also wider factors in play within the Fed’s thought process, such as an inflated stock market, its large balance sheet and the Trump administration’s proposed fiscal stimulus.

Market Reaction: As ever, fast money moves will surround the initial headline. A stronger than expected number historically sends the USD higher and Treasuries lower with the opposite tending to be the case for a weaker number, before markets digest some of the other details of the report.

H/t: @RanSquawk

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.

It's 1994 Again: Why Albert Edwards Expects An Imminent "Bond Market Bloodbath"

Following the Trump presidential victory, two prominent macro strategists have undergone a significant change in their outlook: while David Rosenberg, who started off with a deflationary, and bearish outlook, then flipped to inflationary (and bullish), has recently once more "mean-reverted" and expects a further drop in yields as deflationary forces return, his SocGen peer, Albert Edwards - while still expecting a deflationary "ice age" in the longer-run (in case there is any confusion, he expressly states "make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over") now expects an imminent "bond rout" in the coming weeks as the Fed"s rate hike cycle leads to an aggressive selloff in short- as well as long-term rates. The result will be another "central bank-inspired recession", which will lead to the convergence of yields on the 10Y US Treasury with Japanese and European bonds below zero, as the global deflationary ice age enters the final round.

Edwards" summary of his current state of mind, just as the Fed is about to make (yet another) historic mistake, is - as usual - rather picturesque:

Make no mistake. Unlike most in the markets, I remain a secular bond bull and do not think this 35 year long bull bond market is over. I believe the US Fed has created another massive credit bubble that will, when it bursts, lay the global economy very low indeed. Combine this with the problems of a Chinese economy dependent on increasingly ineffective injections of credit to produce increasingly pedestrian GDP growth and you have a right global mess. The 2007/8 Global Financial Crisis will look like a soft-landing when the Fed blows this sucker sky high. The seeds for that debacle have already been sown with the Fed having presided over one of the biggest corporate credit bubbles in US history. All that is needed now is for the Fed to sprinkle life-giving rate hikes onto these, as yet dormant, seeds of destruction. Accelerated Fed rate hikes will cause tremors in the Treasury bond markets, forcing rates up, most especially in the 2 year – just like 1994. But as yet another central bank-inspired global recession unfolds, I  believe US 10y bond yields will ultimately converge with Japanese and European yields well below zero – in other words, buy 10y bonds on weakness!

And speaking of 1994, and the reason why Edwards is confident that despite the market "pricing in" the Fed"s upcoming rate hikes, nobody has any clue what is about to be unleashed, the SocGen strategist reminds his clients of the Orange County "havoc" unleashed with the 1994 rate hike cycles.

For those few of us in the markets of a certain age, Orange County conjures up only one thing: 1994 goes down in infamy as one of the biggest ever bond market bloodbaths in history culminating at the end of the year with Orange County in California going bankrupt (younger clients in their late 20s will only know the OC as the mid-2000s teen programme based in Newport Beach, which I watched religiously with my then teenage son and daughter).

I remember the 1994 period as if it were yesterday (unlike yesterday itself). Despite the Fed telegraphing the series of rate hikes and market participants forecasting multiple hikes, it was most curious how the market went into total convulsion. I was chatting to my ?similarly young? colleague Kit Juckes about this and he reminded me that the whole yield curve gapped up some 50bp immediately! It was a bloodbath, especially for 2y paper.

For the benefit of readers who may have missed this particular episode in bond market history, Edwards here are some more details of how the 1993/1995 rate hike cycle flowed through to the bond market, and then promptly resulted in an inverted curve.

You really had to be there at the end of 1993 to understand just how widely expected the 4 February 25bp Fed rate hike was. I was at Kleinwort Benson back then and I remember articulating that rates could rise somewhat more than the market expected on our December 1993 macro European tour. There was no real pushback. I have managed to lose my Global Strategy Weekly files from that time to see exactly what I was saying then, but I have my yellowing press cuttings file! From the FT on 8 Feb 1994 I find this, “on Thursday (the day before the Fed’s first hike), Mr Albert Edwards of Kleinwort Benson  wrote: In the US, Alan Greenspan could not have been clearer. He regards 3% as an excessively low rate which has served its purpose to eliminate the banking crisis and alleviate the credit crunch. The Fed does not care what headline inflation is, rates are heading higher. The risk is that the markets do not view a ¼% rate increase in isolation but the first in a series of tightenings, which it will be”. I was not alone in that view. It was quite common on the sell-side. What though we could not anticipate was quite how savage the bond sell-off would be.

Additionally, Edwards also shares two articles from that year, first from Fortune entitled “The Great Bond Massacre of 1994” see link, and also from December, when The New York Times analysed events surrounding the most high profile casualty of that year, namely Orange County, link. In a word the problem was leverage.

Fortune Magazine wrote in 1994, “Just as in the U.S., European bond investors were operating on lots of leverage. That made them just as vulnerable when the margin calls started to come. The result: "You had a snowballing liquidation completely out of proportion to the (economic) fundamentals," says Gilbert de Botton, chairman of Global Asset Management in London. "Both the U.S. and Europe had been overexploited by investors on margin."

“Back in New York, the report of extremely strong 6.3% real growth in the fourth quarter of last year, combined with Greenspan"s well-publicized fears about incipient inflation, struck new fear into bondholders. The Clinton Administration didn"t help matters. "The saber rattling over Japanese trade hurt a lot," says de Botton. "(U.S. Trade Representative) Mickey Kantor"s allusions to the effect that the U.S. was not in favor of a strong dollar was an indirect source of forced selling (of U.S. bonds) by European investors." Fearing currency losses and declining bond values, foreign holders of U.S. bonds began to pull out.

“Given all the leverage in the market, it shouldn"t have been surprising that long rates moved up sharply when the Fed finally began boosting short-term rates. Indeed, some members of the Open Market Committee voiced fears at the February 4 meeting that even a small increase in the Federal Funds rate could rattle the bond market. Rattle it did. The initial rise in long rates brought forth a flood of margin calls. Rather than put up more money, which many of them didn"t have anyway, speculators liquidated their holdings. With individuals bailing out of bond mutual funds as well, and little or no new money  coming into the market, bond prices had nowhere to go but down."

Edwards" rhetorical question, here: "Does that snippet not sound eerily reminiscent of current events?"

He also points out that while the Fed has so far hiked rates twice in the current tightening cycle, "these have become such isolated hikes that the market (Fed Fund futures strip) has lost confidence that the Fed will ever deliver their promises as represented by the Fed dots." With next week"s rate hike, however, all this will change.

There is another key similarity between 2017 and 1994:

The top chart shows that back in 1994, just before the Feb 4 rate hike, 2y yields were trading some 100bp above Fed funds. That one 25bp rate hike prompted the 2y-Fed Funds spread to soar from 100bp to 250bp within the space of three months while the 10y-2y curve flattened rapidly, destroying carry-trade bets along the curve. The key similarity with 1994 is that currently US 2y yields at 1.35% still trade tightly to the current Fed Funds rate of 0.75% (see left-hand chart below). If the market really takes on board Janet Yellen?s much more aggressive rhetoric, then we could easily see 2y yields rise towards the 10y as we did in 1994. If that happens and the US 2y spread with German and Japan continues to soar (see righthand chart below), this will be like rocket fuel strengthening the US dollar

Finally, while Edwards is hardly a technician, he provides two charts to substantiate his claim that a historic bond rout may be imminent: while the right-hand chart shows that US yields have now broken out and are heading to 2.65% and then 2.85% in the short term, it is the left-hand chart that is most interesting, "showing that US 10y yields can rise all the way to 3¼% and beyond and the secular Ice Age bull market in government bonds would still be intact."

Edward"s conculsion: "In 1994, it was excess leverage that broke the market, culminating in December 1994?s bankruptcy of Orange Country and also the Mexican Peso crisis in that same month (due to dollar strength). I?m going to look harder for my 1994 Global Strategy Weekly file, for despite remaining a secular bond bull, I think we are in for a rough ride - especially with equity markets at record highs."

Atlanta Fed Slashes Q1 GDP To Only 1.3% With Yellen Set To Hike

One week ago, we pointed out a curious bifurcation: the Fed was telegraphing an imminent rate hike - one which following Yellen"s Friday conference is now virtually assured - even though it appears the FOMC would be hiking in a quarter in which GDP comes in in the mid 1%-range, or lower. The reason: while "soft data" - which is important to animal spirits if not actual economic output - continues to surge, the "hard data", that which actually matters to the economy, is still disappointing.

Fast forward one week when according to the Atlanta Fed, Janet Yellen is about to dig an even deeper hole because should the Fed hike next Wednesday it will do so in a quarter in which GDP was just revised from 1.8% as of last week to just 1.3%. This forecast was more than double, or 2.7%, as recently as one month ago.

From the source:

The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2017 is 1.3 percent on March 7, down from 1.8 percent on March 1. The forecasts for first-quarter real personal consumption expenditures growth and real nonresidential equipment investment growth fell from 2.1 percent and 9.1 percent, respectively, to 1.8 percent and 7.3 percent, respectively, after Thursday"s motor vehicles sales release from the U.S. Bureau of Economic Analysis. The forecast of the contribution of inventory investment to first-quarter growth fell from -0.50 percentage points to -0.72 percentage points after yesterday"s manufacturing report from the U.S. Census Bureau.

 

What is curious is the dramatic divergence between the Atlanta Fed and the Dow Jones, one tracking the real economy, the other perhaps tracking euphoria and "soft" data...

... but even more curious is the correlation between the Atlanta Fed"s GDPNow forecast and the inverted April Fed Fund Futures: this means that the worse the economy gets, the higher the Fed odds of a rate hike.

Does any of this make sense? Of course not, but then again in a world in which even the OECD no longer can explain the divergence between markets and the economy, and openly slams central banks for creating asset bubbles, nothing is supposed to make sense.

USDJPY Surges After Brainard Says "Rate Hike Likely Appropriate Soon"

One day after a duo of Fed presidents unleashed the biggest plunge in 2 month Fed Fund futures since 2008, sending March rate hike odds from 50% to 80% in under two hours...

...and resetting the market"s expectations for a March Fed meeting, which suddenly went "live" after NY Fed President William Dudley and SF Fed chief John Williams signaled in separate speeches Tuesday that a rate hike will be considered in FOMC’s March meeting, moments ago the Fed"s uberdovish governor Lael Brainard joined the hawkish parade when in prepared remarks for an event at Harvard, she said that “assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path."

She also said that “we are closing in on full employment, inflation is moving gradually toward our target, foreign growth is on more solid footing, and risks to the outlook are as close to balanced as they have been in some time."

Once the headlines from her speech hit, the USDJPY saored, and has since hit intraday highs, on renewed expectations that another 25 bps rate hike may be due as soon as March 15, when the next FOMC meeting takes place.

Some other hawkish statements:

• “The past few months have seen continued progress in the labor market."


• “Inflation has moved up lately as the effect of past increases in the dollar and declines in energy prices have faded"


• "Core inflation has been below 2% target, and further progress is needed to reach and sustain symmetric inflation goal"


• “Recent months have seen an increase in the upside risks to domestic demand."


• “Near-term risks to the United States from abroad appear to have diminished."


• “How fiscal policy affects the economy depends on a lot of things, and of course there’s a lot of uncertainty,”

Brainard also touched on another sensitive topic, namely the Fed"s balance sheet, saying that “as the federal funds rate continues to move higher toward its expected longer-run level, a transition in balance sheet policy will also be warranted." She also added that “there are good reasons to expect a normalized balance sheet to be considerably smaller than its current size but larger than its pre-crisis level."

Some additional observations on her comments from Stone McCarthy:

• The March meeting is squarely in focus for a possible rate action in the wake of strong economic data and measures of inflation at long last nearing the Fed 2% objective.


• Most policymakers are still speaking in terms of gradual hikes, but also moving "sooner rather than later" to avoid having to more sharply increase rates if growth and/or inflation starts to pick up.


• Recent comments from Brainard"s fellow FOMC participants certainly suggest that hawkish sentiment is growing among the voters. However, only Chair Yellen speaks for the FOMC as a whole and it is her remarks on Friday at 13:00 ET that will be decisive.


• Brainard said, the economy is "closing in on full employment" and inflation is moving "gradually" back to target, and that "it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path".


• Brainard mentioned "increased focus on the balance sheet", and that it will need to be adjusted relative to the fed funds rate depending "on the degree to which they are substitutes". Might prefer fed funds rate as "sole active tool away from the effective lower bound". Once well away from lower bound, "balance sheet would be set on autopilot" to shrink "in a gradual, predictable way".


• Near term risks from abroad are "diminished" and overall risks are about balanced.

But it was Brainard"s last statement that was the most interesting, if not ominous: "We are going to be in a slightly different kind of posture, I think, going forward."

Hint aside, all of these statements could be merely trial balloons to test the market"s preparation for an upcoming rate hike: for the real arbiter look to this Friday"s speech by Janet Yellne: if she turns as hawkish as her FOMC peers, than a March hike is effectively assured, especially with the March hike odds now at or around 70%.

Watch Brainard live below:

Traders Throw In The Towel On March Rate Hike

As we previously noted, while speculatrs had been reducing their shorts in Treasury futures, they had added to Eurodollar shorts - pushing their bets on Fed rate hikes to record highs. However, as Bloomberg notes, signals are starting to emerge that traders who built up that heavy short, or hawkish, eurodollar base since the start of 2016 could be starting to throw in the towel on a March Fed rate hike.

CME confirmed that Wednesday saw record volume in fed fund futures of 658.7k contracts, beating the previous record of 613k on Nov. 9, the day after the U.S. presidential election. Over the course of Wednesday’s session, a total of 283k Apr fed funds futures contracts traded, largest single-day volume seen in the contract. Open interest in the contract rose by 109k, suggesting some short covering before the minutes and potential new longs after the minutes.

The March/May fed funds spread steepened to YTD wides, further suggesting short covering in March hike positions.

Morgan Stanley said in a note, adding that “hawkish investors increasingly gave up on March and continued to shift their focus to May”

So much for all that jawboning about March!!

Yuan Downside Breakout Is On And What It Means (Spoiler Alert: Nothing Good)

Submitted by Eric Bush via Gavekal Capital blog,

The onshore yuan exchange rate (CNY) against the USD  has eclipsed 6.74 today while offshore exchange rate (CNH) was pushing 6.75 as the week drew to a close. Current levels are at 6-year lows against the dollar and it will be interesting to see what happens as we approach 6.80-6.85 as this was the line in the sand for about two years from 2008 to 2010.  All in all, however, it seems that the continuation of the devaluation that we have been waiting for is officially back on. So assuming that many of the strong relationships that have been in place the last several years hold, what should investors be mindful of?

Starting off with commodities, copper could be ready to take another leg lower and take out 2016 lows. Also, the current price of oil looks high.

Even in a ZIRP world that feels awash with liquidity, a weaker yuan could negatively affect liquidity on the margin. China’s forex reserves are already $800 billion below 2014 highs. This declining trend looks set to continue. Additionally, liquidity in the US banking system will probably continue to be drained as non borrowed reserves decline.

US economic prospects aren’t very bright with a China in currency devaluation mode. The non-oil trade deficit will probably continue to widen while overall corporate profits decline. Non-oil import prices will most likely continue to depress any sign of inflation which keep pressure on nominal GDP growth and non-residential fixed investment. Additionally, this could all depress breakeven inflation expectations as well.

We would also expect to see fed funds futures creep higher (i.e. lower chance the Fed raises rates) especially in 2017. 2017 fed fund futures have already increase by 7 bps over the past week. We could also see a rally in long bond prices and higher USD 3-month LIBOR rates (which will make hedging costs for foreign buyers of treasuries more expensive).