Fed to deliver dovish signal

Rates

Global core bonds ceded some ground yesterday. The main move occurred around European noon after China Central Television reported the country would firmly implement major reforms and deepen supply-side structural reform. The fact that such headline manages to impact trading is more of an indication of low volume action ahead of tonight's Fed meeting than anything else. Economic data printed mixed. The German yield curve bear steepened in a daily perspective with yields adding 0.2 bps (2-yr) to 1.4 bps (30-yr). The US yield curve bear flattened with yields ending 1.7 bps (2-yr) to 0.4 bps (30-yr) higher. 10-yr yield spread changes vs Germany ended close to unchanged with Portugal and Italy (+3 bps) underperforming.

Asian stock markets are mixed this morning after WS's late swoon with China underperforming (-0.5%). Media reports on US-Sino trade talks are mixed. Some US officials are concerned that China is pushing back against American demands, but key officials (Lighthizer, Mnuchin) will travel to China next week to continue high levels talks with vice premier Liu He. Core bonds tread water going into the European opening. The sole focus of today is tonight's FOMC meeting.

Fed chair Powell already suggested in front of US Congress to halt the balance sheet run-off by the end of the year. That's much sooner than the Fed originally had in mind and market participants had expected until the turn of last year. Communication on the composition of the Fed's portfolio is a wildcard. The Fed might eg opt to continue to let its MBS-portfolio run off, but replace them by US Treasuries. Another factor the Fed might tweak is the duration of its Treasury portfolio. Shortening it would be considered hawkish and vice versa. Apart from this, we expect the Fed's plotted rate hikes to drop from 3 currently (2 in 2019 and 1 in 2020) to 1 (in 2019) taking into account weaker growth and inflation forecasts. The Fed's feared inflation overshoot didn't happen last year, putting governors at ease to take a more wait-and-see approach as the economy shows first signs of sputtering. Markets remain even softer positioned with unchanged rates this year and a rate cut in 2020.

US rate markets are positioned for a soft message. Ending the BS run-off and lower dots are probably discounted. The accents of Powell's press conference or possible details on the composition of the Treasury portfolio are wildcards. Current positioning might dampen the immediate market impact, but we expect the Fed to create fertile breathing ground for additional bond gains over the medium term, flattening the curve. The US 10-yr yield can drift lower in the 2.49%-2.8% broad sideways channel.

Download The Full Sunrise Market Commentary