At 2 p.m. EDT today, March 19, the Federal Reserve Bank will release its monetary policy statement. This will be followed by Janet Yellen's first press conference at 2:30 p.m. EDT.
There have been a range of discussions about what Yellen will do at her first meeting. Some ideas include the following: change the forward guidance to a more qualitative approach (the Fed already has), taper at a faster or a slower rate, or monkey with the forward path of rates. My inclination is to think the Fed will be less dynamic with its changes in policy than investors and traders have been conditioned to think. The most powerful effect today should come from any adjustments in the Federal Open Market Committee's (FOMC) economic projections, to which interest rate markets will react. A $10 billion taper is a non-event.
I'm really paying attention to these three things:
- Literally every Fed speech since the January meeting has included the idea -- in one form or another -- that altering the pace of asset purchase tapering is a "significant" monetary policy step. It is the Fed's way of saying that it wants to have another bullet in the gun just in case it needs to be fired, meaning that it will quicken the pace of reductions if there is a pickup in economic activity and reduce the pace if there is a slowdown. I think the Fed will say that even though economic activity has softened in recent months, there is no significant (or some similar adjective) change in the economic outlook to justify a change in monetary policy.
- I have seen a few notes arguing that the Fed will embrace a lower long-term Fed funds rate. With regards to the long-term path of the fund rates, the Fed has already been putting this idea on the table since its July meeting. The idea -- one that I am completely on board with -- is that structurally low growth and inflation will move the long-term neutral rate down from 5% to between 3% and 3.5%. Here's a quick recap of "what" that does. At its basic, interest rates (Treasuries) are the extrapolation of 12-month T-bills compounded "X" years into the future. The 12-month T-rate is directly correlated with the Fed funds rate, so essentially, the 10-year Treasury is the compounded rate of return on your cash nine years in the future. The market then adjusts that "curve" of returns for perceived changes in inflation, which the Fed would react to by lowering or increasing the overnight rate.
- Another possibility is that Yellen discusses the usage of the FOMC's Economic Projection as a more direct policy tool. I can't see this having any effect because the market has already priced that in (and out) up to this point. If there is any change in the projections, then the Treasury market will re-price accordingly. But short of that, I don't expect anything else.
There is an argument that the Fed will drop the 6.5% unemployment threshold. Well, it already is doing so. Federal Reserve Bank of Chicago President and CEO Charles Evans, the creator of this threshold, stated in a speech in October of last year [subscription required] that the thresholds weren't appropriate anymore. Besides, the market has already moved past this, so I would not be paying attention to something that doesn't matter anymore.
Positioning wise, everything I have seen for Treasuries has a bearish inclination. So even though the consensus view I have been reading in strategy notes is that Yellen will engineer some change in forward guidance without spooking the market, I believe that there is a higher chance of yields ending up lower following the meeting. I am not making a bet on that possibility, though, nor am I hedging my current bond holdings.
On the opposite side of that is the term premium (the difference between the term rate and the "cash" rate) on a 10-year note. As of this morning it is four basis points (according to my calculations), meaning that there is a very low risk premium being priced into the Treasury market for future inflation risks. That is quite low, considering traders saw between 25 and 30 basis points late last year, but this indicates that the market is fairly priced at these levels.
My thinking is that the Summary of Economic Projections (SEP) will more than likely reveal lower growth forecasts for 2014, which would be a positive for Treasuries. If that is the case, I would look to sell that rally. However, the market has been coiling for the past seven weeks, so my sense is that something explosive is around the corner.
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