Fed preview: Look for a positive twist – will the market take notice this time?

At the recent semi-annual testimony, Fed chairman Janet Yellen turned less dovish by saying that “if the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.”

It thus seems likely that the Fed statement on Wednesday will also have a hawkish twist giving an acknowledgement that the labour market is improving faster than expected.

Although the recent CPI print was a bit lower than expected, one cannot rule out the possibility that FOMC may also choose to adjust the language on inflation in a slightly less dovish direction. A number of different core inflation measures (core PCE, core CPI, median CPI by Cleveland Fed, core sticky prices by Atlanta Fed) have all started to move higher. Last month FOMC took no notice of the rise in inflation but Fed members are increasingly mentioning it in speeches. It could very well lead to a slight change in the statement as well.

So far the bond market has been quite unaffected by the comments by Janet Yellen and other Fed members that have become less dovish (see overview below). But if the Fed statement repeats the message, the market may increasingly start to believe in the Fed’s own projections. Money market rates are still priced around 70bp below the Fed’s own projection at the end of 2016 (market 1.80% versus Fed median projection of 2.5%).

In fact the Fed might be a little concerned that the market is not changing its policy expectations in line with the data and Fed rhetoric. The Fed prefers a smooth transition of expectations in the market rather than a sudden abrupt change if Fed policy changes diverge too much from market pricing. For this reason, the Fed may also choose to adjust the language in a more hawkish direction at this point.

On policy changes it is almost a done deal that the Fed will taper another USD10bn, taking asset purchases down to USD25bn per month from USD35bn per month.

Looking ahead we expect the first hike from the Fed in June 2015 but the risk is increasingly skewed towards an earlier hike given the improvement in the labour market. The market is currently pricing the first hike during Q3 15.