- Fed will stay on hold while lowering the ‘dot’ signal for 2019 to one hike (from two). We will not be surprised if the Fed signals “one and done”.
- Our base case with two hikes this year will be under pressure if the Fed confirms it has changed its reaction function by looking more at inflation expectations.
- We expect the Fed to announce it will end shrinking the balance sheet in Q4 19.
- Impact on fixed income should be limited even if the Fed completely remove all hikes from the dots.
Fed outlook: Fed is likely to signal just one more rate hike
We expect the Fed will keep the target range unchanged at 2.25-2.50% and make no major changes to the statement.
Powell & Co have emphasised that they will be “patient” in raising hikes but the question is what that means in terms of the “dots”, which are released alongside the rate decision. The U.S. macro outlook is still positive but Fed stated already in December it wants to see it confirmed before continuing its hiking cycle. In addition, the Fed is concerned about possible spill-over effects from the slowdown in China and Europa, and therefore also want to wait and see how things evolve in the global economy. The Fed also wants to make sure the rebound in risk appetite so far in Q1 19 is robust. We expect Fed to lower its ‘dot’ signal further to just one rate hike in 2019 (down from two). We expect them to be revised lower also for 2020 and 2021 and we will not be surprised if the Fed signals “one and done”. We expect the longer-run dot is to be unchanged at 2.75%. That said, Fed has begun downplaying the importance of the dots given the increased uncertainty around the base case, so be careful putting too much weight on them going forward.
Our current base case is two Fed hikes (in June and December) based on our overall positive economic outlook. Economic growth is strong, unemployment rate is moving lower, wage growth is moving gradually higher and risk sentiment in markets has rebounded. PCE core inflation, however, has softened in recent months. However, if the Fed confirms it has changed its reaction function by looking more at inflation expectations and less on the unemployment rate, a June hike seems less likely, as marked-based inflation expectations remain well below historical average.
Still, markets are pricing the Fed too dovish at the moment, as they think the Fed is on hold for the rest of the year. A change in Fed’s rhetoric can happen fast. A good example is the rate increase in March 2017 where the market was not expecting a rate hike until Fed signalled it three weeks in advance.
We believe the Fed will announce it will end shrinking its balance sheet in Q4 .
Fixed Income: The market has priced Fed on hold
The market is already pricing that the Fed will stay on hold at the March meeting and the market impact should be limited even if the Fed completely remove all hikes from the dots. Even if the pencil in one more hike during 2019 the market will probably ignore it for now. But if we are correct we might see a small bearish repricing of the US money market curve. The market is pricing some 5bp of rate cut in 2019 and a full 25bp rate cut in 2020.
During 2019 we have seen the FRA-OIS spread (3M USD Libor – 3M OIS Swap) tightening some 20bp since mid-December 2018. It has helped pushing 3M USD Libor down from 2.82% to currently 2.61%. The lower 3M USD Libor has been a result of the market pricing an end to QT, as there is now less fear of a tight dollar liquidity situation in 2019 due to QT. Hence, if Fed does not announce an end to balance shrinking, as we expect, the FRA-OIS spread could widen again
