Wednesday’s announcement and forecasts by the Federal Reserve Open Market Committee provided USD bulls with a much-needed boost after it was revealed that 12 of the 16 members of the FOMC are expecting one more Fed hike before year-end. Despite weakening inflation, the Fed remains optimistic about the economy. The Fed also announced it would start reducing the balance sheet of its bond portfolio next month.
Does the Market Agree?
The market doesn’t share the Fed’s aggressive forecast for a rate hike in December and three more hikes next year. For December, the bond market has lifted odds of a 25-bp rate hike to 64% from around 55% before Wednesday’s FOMC. But traders are also aware that as much as a 1/3 of the FOMC will change next year (see more below).
Inflation Mystery?
One striking aspect of Yellen’s conference was her admission that the decline in inflation was a “mysteryâ€. Core inflation went from 1.9% in October 2016 to 1.4% in July. Yellen said the lagging effects of weaker energy prices and a stronger US dollar were partly responsible for low inflation, while technology also continued to be instrumental in weighing down on costs. With USD has fallen 10% and oil prices recovering off their lows, does it make sense to expect inflation to stabilise and open the door for that December Fed hike? That is the thinking/wish of the Fed.
But I see lasting obstacles in the face of rising inflation. Selling $10 bln worth of bonds every month in addition to a prolonged constraints on the fiscal side (debt ceiling and limited scope for fiscal easing) will make matters difficult.
Balance Sheet Reduction
As expected, the Fed will start reducing its balance sheet in October by selling $6 billion in US Treasury bonds and $4 billion in mortgage bond securities. The purchases of treasuries will increase by $6 bln at 3-month intervals and by $4 bln at 3-month intervals for MBS. Theoretically, the selling of bonds would drive up bond yields across the board. But just as theory did not work well when yields rose during the Fed’s QE, it is likely that yields will not rise during the selling of bonds. That would especially be the case once the withdrawal of Fed stimulus from the markets is combined with tapering from the European Central Bank and tightening from the Bank of England and Bank of Canada.
