FOMC Meeting Preview
The FOMC begins its two-day June meeting today; its last meeting was held on April 30. The meeting will conclude tomorrow with the usual statement release and a subsequent press conference by Chair Janet Yellen. For the first half of 2014, there will have been four FOMC meetings. Four meetings remain in the second half: July 30, September 17 (followed by Chair press conference), October 29, and December 17 (followed by Chair press conference).
Investors should fully expect the Fed to announce that the overall pace of its monthly asset purchases will be reduced from the current $45 billion to $35 billion. The pace of Treasury purchases will moderate from $25 billion to $20 billion, and the pace of mortgage-backed security purchases will moderate from $20 billion to $15 billion. The program, otherwise known as “QE3,” is on track to end in the fall.
Markets will also get a fresh look at the FOMC’s expectation for the fed funds rate in the coming years. At the March meeting, the FOMC announced that the current 0.25% fed funds rate would lift to 1% at the end of 2015, and 2.25% by the end of 2016. These expectations are referred to as the “dots” and will be heavily watched tomorrow.
Some have suggested that the FOMC will need to address and lower its 2014 GDP forecast in its summary of economic projections due to the weather-induced 1% contraction in the first quarter. Yes, expect that to occur. This may also motivate the Fed to lower slightly its 2015 and 2016 fed funds rate expectations.
While lowering the dots will be viewed as near-term dovish and a headline grabber, please be cautious with that expectation. The FOMC may balance any dovish view with the following acknowledgments, which, if they persist, will lead to a much faster first fed funds rate hike and assuage the FOMC hawks:
- A better inflation outlook and improving deflation outlook
- Recognition that the unemployment rate is falling quicker than expected
- The rate may fall to 5.5% by Q1 2015 without a substantial rise in the labor force participation rate
- Language that highlights financial conditions are at their best levels since pre-2008 credit crisis
I also expect it is time for the FOMC, whether in its statement or during Chair Yellen’s press conference, to telegraph the Fed’s balance sheet exit strategy. How exactly will the excess reserves in the banking system be removed? Yes, the Fed will “naturally” shrink its balance sheet as assets mature, but in order to lift short-term rates, there must be a process to drain the liquidity in the banking system and, at the very least, stop reinvesting maturing debt.
Answers on an exit strategy will not be provided at this week’s meeting. However, I expect it is nearing the moment when having FOMC guidance will matter to the markets. My expectation is that investors could be challenged by rising rates much earlier than currently perceived by the capital markets. The output gap is shrinking, and recent measures of economic activity suggest a strong rebound from the first quarter weather-induced contraction.
The value of the 10-year U.S. Treasury (Figures 1 & 2) fell from 2.645% on the day of the last FOMC meeting, April 30, to a 10-month low of 2.40% on May 29. Over the past few weeks, the yield is attempting to recover back toward its late April levels. Keep a focus on its activity in the wake of tomorrow’s statement and press conference.
There are muted expectations for any capital markets-related impact from tomorrow’s meeting. I caution investors not to dismiss this meeting quickly as a bore; in the long run that could be a mistake.
Figure 1: U.S. 10-Year Treasury Yield, 2014
Figure 2: U.S. 10-Year Treasury Yield, January 2013 to Present