Fed preview: Start talking about talking about tapering?

Key takeaways

• We doubt that the upcoming Fed meeting will be a significant one.

• In particular, we are looking for changes in the communication on QE. We think the Fed will repeat that bond buying will continue at the current pace “until substantial further progress has been made” but that Fed Chair Powell will acknowledge that tapering discussions have moved closer at the press conference.

• We expect the Fed to signal one rate hike in 2023 (from zero currently).

• FX: Tighter liquidity in the US and China will strengthen USD eventually but the exact timing remains highly uncertain.

• Fixed Income: We see risk tilted to the upside for Treasury yields this week but we probably need to see the actual tapering announcement before we should expect a new significant move higher in US treasury yields. We still see 10Y US treasury yields around 2% year-end.

Watch out for Fed communication on QE

We doubt that the Fed meeting will be a very significant one. Inflation has moved higher but inflation expectations are still at acceptable levels given the Fed’s new average inflation regime (for more details see Research US: Higher inflation but not spinning out of control due to still well-behaved expectations, 14 June), so the Fed is likely to repeat that some of the price increases are transitory in nature (i.e. repeat that “Inflation has risen, largely reflecting transitory factors”). If anything long-term market-based inflation expectations like 10yr breakeven inflation has actually moved a bit lower recently. Clearly, the Fed is employment-focused at the moment and employment still remains significantly below the level before the pandemic. We discussed the Fed’s reaction function in more detail in Fed Monitor: “Still a long way to go” – Fed is currently employment-based, 10 May. On outlook risks, we expect the Fed to repeat that “risks to the economic outlook remain”.

In our view, the most important thing to look out for is the Fed communication on QE. The Fed has repeated again and again that it will continue buying bonds at the current pace “until substantial further progress has been made”. Unfortunately, the Fed does not want to quantify what substantial further progress really means. We took notice of Fed Vice Chair Richard Clarida saying that “It may well be that in upcoming meetings, we’ll be at the point where we can begin discuss scaling back the pace of asset purchases”. “A number of participants” said the same thing at the April meeting according to the minutes. We think the Fed, for now, will stick to the current wording but that the Fed Chair Powell will recognise that tapering has moved closer during the press conference. If not, we expect policymakers to say it in speeches after the meeting, when the blackout period expires.

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