Fed preview: What to do in a bad trade-off?

Key takeaways

The Fed is in a difficult position amid slower growth and still high inflation. Given the weak jobs report and lower-than-anticipated inflation in August, we expect the Fed will refrain from providing more details at this meeting, as the Fed has already made it clear that tapering is set to begin before year-end.

We believe the tapering pace is more important than the timing. We continue to expect that tapering will be concluded in mid-2022.

We expect the Fed to raise the ‘dots’ by signalling the first rate hike in 2022 (up from 2023 currently). We still expect the first rate hike in H2 2022 in either September or December.

Fixed Income: We expect the imminent market reaction should be muted in the US fixed income market if we (and consensus) are right. However, we see risks tilted to the upside. We still forecast 10yr US Treasury yields in 2.0% in 12M.

FX: The continued push towards tighter global liquidity conditions (Chinese deleveraging, ECB fading PEPP and Fed tapering) is positive for the dollar. We continue to see downside risks to EUR/USD over the coming year, targeting 1.15 in 12M (1.13 in 15M).

Fed Preview: No tapering details yet after weak jobs growth

We believe the Fed finds themselves in a very difficult situation. Normally when the economy is hit by a negative demand shock, it makes sense to ease monetary policy to support both employment and inflation. As the current situation looks a bit more like negative supply shock (although the delta variant is making the picture more blurred) with bottlenecks, lack of qualified workers, rising commodity prices, higher inflation (expectations) and so on, the Fed has to decide whether to fight high inflation (tighten) or low employment (easing). At least, the high inflation prints and increasing inflation expectations (especially 1-5 years expectations) among households make it more difficult for the Fed to remain patient.

There were a lot of speculations that Fed Chair Jerome Powell would announce more details about tapering in connection with his speech at Jackson Hole, which he did not. After the weak jobs report for August, we think the Fed will refrain from giving more details at the upcoming meeting, which is in line with what investors and consensus think. Waiting a bit longer also gives the Fed a bit more timing analysing why the jobs report was weak. Was it just noise or a signal of something else? We discussed exactly that in US Labour Market Monitor: Weak jobs report – noise or a signal of something else?, 13 September. The lower-than-anticipated CPI inflation print for August also supports this call.

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