Friday, February 24, 2017

FOMC | The Ides of March

We have quite a bit of built up anticipation for the March FOMC. The Fedspeak analysis of "Fairly Soon" has been interpreted by most as leaning towards a March hike. Some are even claiming the rates markets are underestimating the probability of a March hike.
The chart above shows implied 3-month treasury forward curve term structure since the 2014 (after the highs from 2013 Taper Tantrum). In early 2014 the market estimates of long run equilibrium rates were just about 4 percent. Since then we have come a long way. As we see we have three major clustering of market estimates - one at around sub 2 percent (during Brexit rally), another just above 2 percent (early 2016) and the most common level at just about 3 percent. The sell-off after the US presidential election has just brought us back to this 3 percent level. Coincidentally, after disagreeing with the markets on this long run terminal rate for a long time (erring consistently on the upper side), the FOMC also now more or less agrees with this level. So after quite a while markets and the FOMC seem to have converged in outlook. 

Given this background, I think whether the FOMC hikes in March or not is now a far less important question than what it used to be a couple of years or even a year back. Before March FOMC, we have a round of PCE (Fed's favored measure of inflation) as well as employment and GDP data release scheduled. Unless we have a major upward surprise, March probably will be a no-hike meeting. And more importantly, given the improving economy, markets are in a much better position to absorb a hike anyways. The US and global inflation are improving, but it is much tamed than the "reflation trades" coverage makes it sound. Inflation was a worry (on the downside) before, now slowly it is ceasing to be so. There are few signs the FOMC is behind the curve as of now.

What can really take the market off-guard, is however, the question of Fed balance sheet. If and when FOMC plans to reduce its QE-bloated balance sheet, and how they communicate this point. Hiking is a way of tightening. But a controlled balance sheet reduction is also another way. While the former affect the short term rates more (a bear flattening), the later should be more prone to affect the long end rates (bear steepening). A reason why FOMC may actually opt this is to address the historically compressed risk premia - see the left chart below. Even with the recent sell-off, the risk premia remain at a depressed levels. The short end pressure felt on the back of FOMC moves more or less leaned towards a flattening of the curve than any significant correction of risk premia. While the European and Japanese bonds are trading at super-depressed levels, perhaps it is not entirely to the Fed to correct this. But adjusting balance sheet is definitely a direct way to address this.

The most important reason NOT to do this it the unpredictable potential impact. This has the strongest potential to send confusing signal to the market, perhaps resembling a taper tantrum version 2.0. The right-hand chart above shows a quick check to identify the pain points based on the current Fed holdings vis-a-vis supply. The vulnerability is concentrated in the long end, especially if this is adjusted for the duration risk (not shown here). The primary reason this may create unwanted responses is that it is not at all well understood. Balance sheet reduction after a massive QE is a completely new thing for both the Fed and the market. The last FOMC minutes (published last week) discussed this issue explicitly for the first time, if I remember correctly. So it is fair to expect this will definitely come up in the March discussion as well. At present FOMC expects re-investing to continue "until normalization of the level of the federal funds rate is well under way". The most important event for the markets from the March FOMC will be any potential change on this view. 

Realistically, this can be the trigger that can bring us back to the 4-handle level of long term equilibrium rates we had at the end of 2013. Trump fiscal push blow ups and run-away inflation seems pretty far-fetched at present. The asymmetric positioning here is bear steepening.

Similarly on the equity and risk assets side, this can have the most unexpected and damaging impact than a regular FOMC hike. Possibly more than even an adverse French elections. The National Front candidate Marine Le Pen, even if elected as the President against all odds, will find it hard to muster enough support in the parliament to call for a national referendum to leave the Euro area. And even if the referendum is held and a majority votes to leave, it is not clear that will actually be followed through - going by the outcome of the 2005 referendum.

all data from Federal Reserve and US Treasury.