Tuesday, March 16, 2021
This week, the Federal Reserve (Fed) meets for their two-day Federal Open Market Committee (FOMC) meeting, which concludes on Wednesday followed by a press conference with Fed Chairman Jerome Powell. If we were invited to the press conference, here are five questions we would ask Chair Powell—each of which may meaningfully impact fixed income markets.
1. Why have (or haven’t) the Dot Plots changed from their December FOMC meeting? The Fed’s Dot Plots represent the committee’s expectations of where the federal funds rate should be over the next few years, ending with their longer-term expectations. Current projections have the federal funds target rate unchanged at 0-0.25% through 2023. These projections were before the recently enacted $1.9 trillion COVID-19 relief bill and before the success we’ve seen in vaccine deployment. Growth and inflation expectations have increased significantly since then, so is it time for the Fed to change the expected path of short-term interest rates?
2. Has the Fed started thinking about thinking about raising short-term interest rates? Back in June 2020, Chairman Powell famously quipped “We’re not even thinking about thinking about raising rates,” in an effort to reassure markets that the low interest rate environment was here for some time. While we don’t expect the Fed to announce plans to raise rates anytime soon, the market has started pricing in an earlier liftoff (early 2023) than the Fed has communicated. It will be interesting to see if the Fed pushes back against these market expectations.
“The Fed has been one of the biggest stories in bond markets over the past several years. What will they say about inflation, about the economy, about the next rate hike, and about future bond buying? It all matters, so stay tuned,” explained LPL Financial Chief Market Strategist Ryan Detrick.
3. Will the Fed change its bond buying behavior? Additional quantitative easing programs are off the table, in our view. However, under the current program, the Fed has committed to buying $80 billion in Treasury securities and $40 billion in mortgage-backed securities (MBS) each month for the foreseeable future. Eventually, we believe the central bank will announce a reduction in bond purchases, likely before the Fed is ready to communicate an increase in short-term interest rates. Hoping to avoid a repeat of the 2013 Taper Tantrum, we think current Fed officials will eventually announce a gradual decrease in purchases. While we don’t think this will happen at this FOMC meeting, it’s likely to happen later this year and may push interest rates even higher.
4. Have the bond markets been focusing on the wrong thing? Chairman Powell has repeatedly said that the Fed is not focused on the level of one financial variable (10-year Treasury yields) but rather an index that captures overall financial and economic conditions. Nonetheless, largely due to an increase in yields over the past month, bond markets increasingly expect the Fed to intervene to slow the pace of the increase (similar to what the European Central Bank (ECB) did last week). However, as shown from the LPL Chart of the Day, rising interest rates have not negatively impacted financial conditions, at least not yet. Despite the 10-year yield rising over 60 basis points this year (orange line), financial conditions (blue line) remain accommodative by historical standards (lower readings indicate accommodative conditions). As long as financial conditions remain accommodative, rising Treasury yields aren’t likely to become an issue for the Fed, which means yields may continue to drift higher from these levels.
5. Will the Fed extend the Supplementary Leverage Ratio exemption? Somewhat technical with this one, but last year a regulatory change was enacted that allowed banks to exclude nearly $2 trillion of Treasury securities from certain leverage ratios. That exemption is scheduled to expire at the end of March 2021. Treasury ownership by banks increased last year to 6% of total assets. Failure to extend this exemption may cause banks to have to sell Treasuries or not be an active buyer of Treasuries in the future in order to adhere to bank regulatory requirements, which may cause Treasury yields to increase.
While we’re unlikely to get answers to all of our questions at this FOMC meeting, the Fed will remain an important story for bond markets for the foreseeable future. As such, we will continue to follow Fed policy changes and update our recommendations as appropriate.
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