Harkster Preview - Fed Decision Tree (Sept 20)

Today’s focus.. 2024 Dot and where does the Fed see r*

Consensus: #1. rates unchanged, #2. "higher for longer" message to remain the same, #3. the '23 Dot will continue to forecast the probability of another hike this year (to maintain flexibility), #4. data dependent focus, not on a predetermined path, #5. it's a skip not guaranteed pause, #6. they will do more, if necessary, #7. watching the data to see how monetary policy impacts with a lag, #8. JPow to reiterate his Jackson Hole speech....   

What can surprise the market? What can change November pricing? Given there is a 50% chance of one more hike priced into the curve this year, as well as the consistent Fed speak that we've heard over the past few weeks, what can we learn this evening to move the needle to adjust the markets rate pricing materially for this year and into 2024. Barring a communication misstep, it's the data (Labour, Housing, ECI and CPI) that prints in the coming weeks before the November meeting that will determine if we're at peak Fed rates, if we've already reached restrictive, if the market's pricing for the Fed is correct and they will be cutting in March 2024. 

Economists surveyed across the street are confident rates will go unchanged,  growth forecasts will be revised higher, but inflation is set to be revised lower. Thus, the only true surprise this evening will be the 2024 dot, how many cuts do the Fed see is needed and if they raise the long run average dot from 2.5% to 2.75%.  

Overanalysing the Dot Plot... 

JPow has said we shouldn't listen to them, their "forecasting success" is no better than a day trader picking up pennies in front of a steam train (where was their 2023 dot meant to be.... 1%?), the current St Louis Fed GDP model contrasts wildly from Atlanta Fed's GDP, by 4 or 5%... However, despite their safety warning, it won't stop the market overtrading the dot plot, what are the Fed trying to tell us!!! (hint: we should already now given how much they speak in between meetings)

... One thing @HarksterHQ finds interesting is the market calling for the Fed to be done, like the ECB but their staff forecasts are the mirror image... ECB raised inflation, the Fed's SEP will lower their estimate whilst the ECB lowered their regions growth forecasts, the Fed will raise theirs. As a result, the hawkish risk this evening is the ‘24 dot being a lot higher than the WIRP pricing, and they use this to re-enforce the "higher for longer" mantra, push back against the markets cuts. The Fed should pause and keep their options open, whereas the ECB are convincingly "done"... that's what the data tells us. 

It is a dovish risk if lowered, but the 2023 dot should continue to show one more hike. The economic momentum is still strong, labour market is still historically tight even if it is showing signs of normalizing and gasoline prices as well as other service inflation indicators are still not comfortably on a guaranteed path sub-2%. As much as USD bears would like to see it, why give away the option of one more hike this year? Why fuel the animal spirits and unnecessarily ease financial conditions? The market won't penalise them for keeping it, especially after the communications of Logan, Bowman and others. 

Their real-rates framework justifies cuts in 2024 (especially if they lower inflation) but the opposing growth momentum and labour market resilience will most likely see a convergence of the 2024 range of forecasts with one less cut potentially now in their 2024 forecast due to the exceptional outperformance of the US economy. The market will not be surprised if the 2024 dot is raised, the question is by how much, how confident are the Fed in their soft-landing scenario. Increased support for that scenario will come if they lower their 2024 UER forecast.  

I'm going to leave it to the experts to discuss the evolution of r*. Given its currently a key anchor to longer dated Treasury yields (which just lost the BoJ dampener) it will be a very important event risk if it is indeed raised... if the neutral rate is raised, the Fed is saying they will have more work to do to get into restrictive territory...  

• SEB: "The New York Fed’s president and permanent voting member of the FOMC, John Williams, in a speech this spring concluded that the natural rate of interest, r*, does not seem to be higher than before the pandemic. Mr Williams is one of the persons behind the Fed’s models for the real rate, the Laubach-Williams model and the extended Holston-Laubach-Williams model, with the latter continuing to signal a real natural short rate of slightly above 0.5% at the end of Q2, 2023. Other New York Fed research at the same time suggests that the short-run r* is currently higher.  Against this background we continue to expect the long-run median rate projection to remain at 2.5%. The fact that more members are leaning towards a higher neutral rate is an uncertain factor. In June seven members thought the neutral rate was above 2.5% compared to only four in March. However, with 10 members still seeing the neutral rate at or below 2.5% in June, we do not expect the balance to shift for a higher median rate in September."
  

• ING: "Our own assessment is that it is likely to be closer to 3%. Fiscal policy has been loosened significantly under the Trump and Biden administrations and we don’t see that changing anytime soon – the Bloomberg consensus is for the US to run a fiscal deficit of 6% out to 2025. This will mean that monetary policy will need to be more restrictive in order to keep inflation under control. On top of this we have the so called “Triple D” of demographics, decarbonisation and deglobalisation, which will all keep upward pressure on inflation and interest rates."

What's in the price: 

• US2s have climbed to their highest levels since the onset of the GFC in 2007. 

• The market and the dots assign a certain probability to the Fed's recent message, giving a nod to one more hike (ie speeches from Bowman, Kashkari and Logan) but also the risk that they're done, close to the finish line (Goolsbee and Harker)

• Pricing from Pepperstone

Harkster Fed Decision Tree:

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• ING: Fed set to hold, but signal the potential for a final hike

• Bloomberg Opinion Bill Dudley: Will the Fed Start Believing in a Soft Landing

• SEB: Unchanged rate in September but too early to declare victory over inflation

• Livesquawk: Fed's Likely Pregnant Pause To Come As Labour Pains Abate

• WSJ: Fed Debates When to Stop Raising Rates. What to Watch at Wednesday’s Meeting

• Fidenza Macro: Short end US rates look mispriced going into FOMC

• Employ America: September FOMC Preview: Holding On to Optionality

• Chris Weston Pepperstone: Can the dots be a new source of market volatilty?

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