Newsquawk Preview: FOMC policy announcement due Wednesday 17th March

HIKE TRAJECTORY

Focus will be on the 2022 and 2023 dots to judge how far the improvement in the economic outlook translates into higher rates in the Committee's view. Currently, market-based pricing assesses that there is a risk of a rate hike in 2022, and has fully priced a rate rise in 2023, which contrasts with the Fed's December projections, where the median forecast saw rates remaining unchanged at current levels (0-0.25%) over its forecast horizon through end-2023; in December, just one of 17 FOMC participants had envisaged a 2022 rate hike, while just five saw rates above current levels in 2023. There is still a chance the median forecast will not envisage a hike, however, despite the Fed being likely to upgrade its growth view. Barclays’ analysts reason that the Fed is likely to see the economy as in a similar fundamental position at the end of 2023 as it did last December; fiscal stimulus will likely push GDP growth higher in the short-term relative to what the FOMC was forecasting last year, but Barclays argues that subsequent growth rates will be slower as federal expenditures retrace, leaving economic fundamentals on a broadly similar footing at the end of the forecast horizon vis-á-vis the Fed’s prior outlook.

INFLATION COMMITMENT

The Fed aims to achieve inflation "moderately above 2% for some time" so that inflation "averages 2% over time and longer-term inflation expectations remain well anchored at 2%"; the key question is how the Fed sees the Q2 2021 inflation spike contributing to the 'average' profile of inflation, and does the expected surge in inflation this year imply less of a need to overshoot later in the cycle? The updated economic projections may reveal what level inflation will be at when the Fed envisages its next hike; for reference, the median of dealers surveyed by the NY Fed in January estimated that headline PCE would be running at 2.2% when the Fed fires its first hike.

QE TIMELINE

Fed officials have stated that the current pace of bond purchases remains appropriate, and rates would not be hiked while the Fed is making these purchases, which implies the timing for QE is pivotal to the timing of future rate hikes. However, officials have also been clear that its guidance is outcome-based, which makes it trickier for market participants to price rate hikes in money markets; Goldman Sachs thinks that without any date-based guidance on QE, front-end rates may need to reprice higher. Powell and Co. have generally been cautious about attaching any date-based guidance to its policy, but have suggested that the pace of QE remains appropriate for now, and can be expected to continue through the end of this year at least. However, considering the more optimistic view about the medium-term, market participants will be keeping an ear out for any conditions the Fed wants to see before it begins pulling back purchases from the current USD 120bln/month pace; analysts at Societe Generale think it would be premature for the central bank to offer specifics given it wants to maintain as much policy flexibility as possible.

PUSH-BACK ON RISING RATES

Officials at the ECB have been far more aggressive in pushing-back against higher EGB yields, last week opting to adjust asset purchases (front loading) to reinforce officials' verbal interventions. The Fed has been reticent to do so, and instead key officials have attributed the recent rise in yields to optimism in the recovery narrative, while others have noted the USD 1.9trln fiscal stimulus package amid an environment where all Americans will likely have access to vaccinations by May. The Fed will have noted that 10-year breakevens last week rose to the highest levels since 2014, and crucially, the rise in inflation expectations was not accompanied by a similar rise in real yields, which analysts at BMO say may provide Fed officials with encouragement. One of the key standouts over the last three weeks has been the Fed’s stoic approach to turmoil in the bond markets, and that approach has been vindicated. This suggests that the statement and the position of Fed Chair Powell will be consistent with recent commentary, suggesting that Powell will steer clear of any detailed discussion of extending the weighted average maturity of Fed purchases further out the curve, and any yield curve targeting policies, although he may remind us that both tools remain in the Fed’s toolbox for use if necessary, while the Fed also has the option to ‘twist’ asset purchases if needed (offsetting short-end sales with long-end purchases). Powell will likely reiterate that while the near-term is mired by uncertainty, the outlook for the second half is brighter, asset purchases at the current rate remains appropriate for this year at least, it will take a great deal of time for inflation to moderately exceed the Fed’s target sustained basis, perhaps three years; there is still a huge amount of progress needed in the labour market.

SLR

Banks' supplementary leverage ratio requirement (SLR) is a capital rule that requires institutions to hold a certain percentage of capital against total assets. In April 2020, regulators exempted Treasuries and deposit reserves from banks' SLR calculations, which allowed these banks to build balance sheets by purchasing Treasuries without hindering their SLRs (some analysis suggests USD 300bln of Treasuries were accumulated over the last year). This arrangement is set to expire at the end of March, and if it were not extended, banks could have to hold more capital against their holdings of Treasuries if SLRs suddenly become the binding capital constraint on banks, which some warn may result in reduced demand for government debt, perhaps triggering in a wave of Treasury selling, which could in-turn reduce funding for other Treasury investors, stoke volatility in fixed income markets, and potentially result in significant market disfunction. Some think that the recent sharp decline in dealers' holdings of Treasuries could be a function of concerns that SLR relief will not be extended, with banks preparing for the possibility that an extension decision does not come. Goldman Sachs (NYSE:GS) dismisses these concerns, noting that the recent decline in dealer holdings was driven by a fall in holdings of Treasury Bills; GS also says that many banks have SLR exemptions at the parent company level, where it is a default exemption, not at the subsidiary level, where banks have to opt-in, which it sees as a sign of confidence that there may not be any forced Treasury selling if the relief was not extended. Other analysts have expressed forward-looking concerns regarding the evolution of bank balance sheets as Treasury issuance continues to balloon and the Fed continues to flood the system with reserves via QE; SLR may not be an issue now, but soon could become the binding restraint. NOTE: any decision on SLR relief is taken at the Fed board-level, and in conjunction with the FDIC and OCC -- it is not made at the FOMC-level, which suggests there is some scope for the issue to not feature heavily at this week's FOMC. Given the issue relates to bank regulation rather than the implementation of monetary policy, it is possible that the FOMC could ignore the issue, although many expect Powell to be pressed on the issue in the Q&A. If the Fed did choose to act, it could do so by either extending the relief, ending it, or perhaps just extending relief for holdings of deposits (reserves), rather than Treasuries.

POSSIBLE IOER HIKE

Intricately linked to the SLR theme is whether the Fed will 'technically' lift the rate of Interest on Excess Reserves, the idle cash that banks hold in excess of regulatory requirements which are then parked at the Fed. In recent weeks, the Secured Overnight Financing Rate (SOFR, the Libor-replacement) has been flirting with negative territory as an excess amount of cash chases a limited amount of collateral. It is important to note that the SOFR is not a Fed policy rate, although it can influence other STIRs as well as the Effective Federal Funds Rate, and Dutch bank ING argues that if it were to fall to zero or turn negative, it might suggest that the Fed has lost some control over the front-end of the curve at a time when the economy is picking-up. The situation might be helped if the pace of Treasury issuance picks up, but that is something that will take months and quarters rather than weeks; if the Fed wanted to act now, ING says it could hike the IOER to lift other liquidity buckets. Some desks look for a hike of between 5-10bps from the current 10bps.