FEDERAL RESERVE (FED)

Attention this week will be on the Q&A part of Fed chair Janet Yellen’s semi-annual testimony to Congress (House Financial Services Committee on 12 July and Senate Banking Committee the next day). The Fed’s Monetary Policy Report, released Friday, provided little new information, reiterating gradual hikes, and gradual reduction of the balance sheet when it begins later this year. Indeed, the report largely echoed recent comments from Fed policymakers, as well as the FOMC’s June meeting.

Yellen’s testimony will likely toe the line, but her Q&A may be more revealing (although we wouldn’t hold our breath: the Fed chair has become increasingly talented at saying a lot without telling us anything new of consequence). Nevertheless, the balance sheet plans, and inflation are the two areas the market would like to hear about.

On the latter, the June meeting minutes indicated that most policymakers saw the recent softness in inflation as having little impact on the trend on inflation, though several were concerned that it might persist, indicating the divide on the FOMC. “The Minutes showed a Fed hiking on realised activity but forecasted inflation,” UBS says, “taken together, strong activity, tight labour markets, supportive financial conditions, decreased risks from abroad, and a belief in their inflation forecasts were enough reason for them to hike.” (NOTE: US June CPI data is released on Friday, which will be crucial in judging how transitory the recent softness is).

• On the former, the key question is around the sequencing of rate hikes and balance sheet normalisation. There seems to be a consensus building that the Fed will begin to normalise the balance sheet in September, with the next hike coming in December, after the minutes revealed several believed normalisation would be appropriate in the next “couple of months”. Additionally, some insight into the logic behind the cap system would be welcomed, UBS says, arguing that the cap system put forward is anything but straightforward: “The asymmetric treatment of Treasury securities and MBS and the fact that the caps become largely irrelevant after a year make for a bit of a head-scratcher. Sadly, there was no further insight into how they came up with their plan.”
• At the close of business on Friday, the market was pricing in a 71% chance that rates would be held between 100-125bps in the July, September and November meetings, with the chance of a hike pretty much a coin flip in December. It is also worth keeping an ear out for comments about the FOMC’s projection for the long-term Fed Funds Rate, currently 3%; it is clear that the market does not buy into that hike trajectory, pricing in just three more hikes between now and the end of 2019, compared with the FOMC forecast that looks for another seven.

Following the dropping of its easing bias at its June meeting, and the apparently hawkish comments of President Mario Draghi at the Sintra conference just a couple of weeks ago, the ECB is clearly uncomfortable with the market’s perception that it would be sending further hawkish signals at its 20 July policy meeting, as suggested by subsequent commentary from officials, as well as other ‘sources’ stories.

To recap on Draghi’s comments made on 27 June: although he declared ‘all signs now point to a strengthening and broadening recovery in the Eurozone, and deflationary forces have been replaced by inflationary ones’, he reiterated that ‘any policy shift would be gradual, and a considerable amount of accommodation was still required for inflation dynamics to become self-sustaining’ (paraphrased).