FOMC Preview and Projections plus the Wildcard to Watch, June 13, 2017

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The Fed meeting is more important than any other this year, for the simple reason that it could either exacerbate the glaring discrepancy between stocks and bond yields (which would be negative for risk assets medium term), or it could help close the gap (which would be positive for risk assets).

Specifically, the bond market has quietly been pricing in the expectation of a “dovish hike” for this meeting via the decline in yields. That “Dovish Hike” means the Fed does hike rates 25 basis points, but makes the statement dovish enough that it doesn’t cause longer-dated yields (i.e. 10- and 30-year Treasuries) to rise. If the Fed executes on that expectation, then we will see the 10-year yield dip and likely test the 2017 lows of 2.14%, and again that is a problem for stocks over the medium/ longer term.

Looking at the actual meeting itself, whether it meets expectations, is dovish, or is hawkish, will depend not only on the rate hike, but also the inflation commentary and any guidance regarding “normalization” of the balance sheet.

What’s Expected: A Dovish Hike. Probability (this is just my best guess) About 70%. Rates: It would be a pretty big shock if the Fed didn’t hike rates tomorrow, so a 25-basis-point hike to 1.25% is universally expected. Statement: In paragraph one, the Fed should include some additional soft language regarding inflation, noting that it’s been soft for a few months. However (and this is important), the Fed should still attribute sluggish inflation to “transitory factors,” implying Fed members are still confident they will hit their 2% inflation goal. Dots: No change to the 2017 dots (so, still showing three hikes as the median expectation). Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Dovish If: No Hike or a Very Dovish Hike. Probability (again, my best guess) About 10%. Rates: It’s widely expected that Fed will hike rates, but there’s always a possibility of a surprise. More likely, the Fed will hike 25 bps and accompany it with a very dovish statement. Statement: The Fed changes the characterization of risks from “balanced” to “tilted to the downside,” or some similar commentary, thereby signaling rate hikes are off the table again. This is a very unlikely, but possible change. More likely is the Fed adding considerable language regarding concerns about lower inflation. Dots: A reduction of the dots to reflect just two rate hikes in 2017. Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Hawkish If: We get a regular hike, not a “Dovish” Hike. Probability About 20%. Rates: The Fed Hikes Rates 25 basis points. Statement: The Fed does not add softer language regarding growth or inflation in the first paragraph, and instead just largely reprints the May statement, which was dismissive of the recent dip in inflation and growth. Dots: The dots remain the same or even increase one rate hike in 2017 (this is unlikely, but possible). Likely Market Reaction: Withheld for Sevens Report subscribers. Unlock by starting your free trial today.

Wild Card to Watch: The Fed Balance Sheet

The market fully expects the Fed to elaborate on when and how it intends to reduce its balance sheet (i.e. the holdings of Treasuries it has purchased over the years through the QE program).

I covered why the balance sheet is important back in April (a link to that report is here) but the bottom line is that when and how the Fed begins to reduce its balance sheet (the term “normalize” is just Fed speak for “reduce Treasury holdings”) could be a substantially hawkish influence on the bond market, regardless of rate hikes.

Specifically for tomorrow, the key detail the market will be looking for is at what level of interest rates does the Fed begin to reduce its Treasury holdings. The number to watch here is 1.5%. It’s widely expected that at 1.5% Fed funds, the Fed will begin to reduce its balance sheet. If we get one more rate hike this year, then that puts balance sheet reduction starting in early 2018 (likely March).

For a simple reference, if the Fed statement or Yellen at her press conference reveals the Fed will reduce holdings before 1.5%, that will be hawkish. If it’s revealed that the Fed will reduce holdings after rates hike 1.5% that will be dovish.

Bottom Line

This Fed meeting is likely the most important of the year (so far), not just because we will get updated guidance on expected rate hikes and the balance sheet, but also because it comes at a time when we are at a tipping point for bond yields (if they go much lower and the yield curve flattens, more people will start talking recession risk). We also are potentially seeing a shift in stock sector leadership (from defensives/income to cyclicals/ banks), so understanding what the Fed decision means for rates will be critically important going forward. You’ll have our full analysis, along with practical takeaways, first thing Thursday morning.

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