- No hike but Fed will announce it will begin shrinking its balance sheet in October. This is widely expected and should not have a major impact on Treasury yields.
- We expect the median ‘dots’ to still signal one more hike this year and three hikes next year. The longer-run median ‘dot’ may be revised down from 3% currently.
- We do not expect major changes to the statement, as it already says the Fed monitors inflation ‘closely’. We are looking forward to hearing Janet Yellen’s view on the dilemma with low inflation and unemployment at the same time.
- Any dips in EUR/USD will be shallow and short-lived but we emphasise that the speed with which EUR/ISD is set to move higher will be reduced going forward.
No Fed hike but announcement on balance sheet reduction
Next week’s meeting is one of the so-called big meetings, which means that we get updated projections and there will be a press conference after the policy announcement. We do not expect the Fed to increase the target range but instead expect it to announce that ‘quantitative tightening’ is set to begin in October. This is widely expected and should not by itself lead to significant market reaction, as the Fed has outlined most details already. The Fed is expected to decrease reinvestments by gradually increasing caps on the amount of bonds that will be allowed to run off each month and only reinvest the amounts that exceed the caps each month. For Treasuries, the cap will begin at USD6bn per month and increase by USD6bn at three-month intervals until it reaches USD30bn per month. For mortgage-backed securities, the cap will be set at USD4bn per month initially and increase USD4bn at three-month intervals until it reaches USD20bn per month. We do not expect quantitative tightening to have a major impact on Treasury yields like the taper tantrum in 2013. The Fed will still have a significant reinvestment need in 2018, but there is a risk that quantitative tightening could lead to an unwarranted tightening of financial conditions. The reason is that we still do not know what level the Fed targets for the balance sheet, which, in our view, is not a trivial question due to increasing regulation, something the Fed has also touched upon previously.
Fed likely to still signal a third hike
Besides the announcement on quantitative tightening, focus is on changes to the so-called ‘dot’plot and the FOMC statement, mainly because of the Fed’s dilemma with low inflation and low unemployment at the same time. While the dovish and hawkish camps have drifted further apart, we expect the median ‘dot’ to still signal a third hike this year, as we do not think four Fed members will lower their forecast (which is the necessary number in order to lower the median ‘dot’). In June, there were already four members (probably Bullard, Brainard, Evans and Kashkari, in our view) indicating no further hike this year but based on recent speeches it seems like only Kaplan may have joined them, although not all Fed members have expressed their opinions lately. In our view, Dudley’s support for further tightening was key, as he is one of the core members of the FOMC (number three after Yellen and Fischer). Dudley argued that financial conditions are very easy and that above-trend growth should put upward pressure on inflation due to the tighter labour market. For the same reason, we think the median ‘dot’ will continue signalling three hikes next year. That said, it is important to stress that while all FOMC participants are submitting their projections, only nine of them have voting rights, meaning that the ‘dots’ are likely to be biased in a hawkish direction, as many of the most hawkish Fed members are non-voters. Also, note that we for the first time will get ‘dots’ for 2020.
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