Street Spooked By Yellen's Upcoming Hawkish Swan Song

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What mutant do you get when you combine a hawk with a swan? According to a nervous Wall Street, the answer will be revealed on Wednesday, Janet Yellen’s final FOMC meeting as Fed Chair, when her swan song statement is expected to send a distinctly more hawkish signal than in December, by observing a more upbeat economic assessment and higher inflation measures, an outcome which could send short-dated yields spiking, lead to further curve flattening, and as for what it does to the beaten down dollar is anyone’s guess, especially if a determined hawkish bias by the Fed is seen as an accelerant to the next US recession.

And the uncertainty on what terms Yellen parts is leading to at least some indigestion among Wall Street analysts, starting with Goldman whose summary take we present below:

At Janet Yellen’s final FOMC meeting next week, we expect the FOMC to issue a generally upbeat post-meeting statement that includes an upgrade to the balance of risks and a slightly hawkish rewording of the inflation assessment. Taken together, we believe the tone of the statement will be consistent with a hike at the March meeting, barring a sharp weakening in economic conditions.

We think Fed officials will view the economic activity data released since the December meeting as broadly encouraging, particularly the strong holiday-shopping season and the related 3.8% increase in Q4 consumer spending.

And with tax reform now signed into law, financial conditions easing further, and the negative effects of the hurricanes clearly in the rear-view mirror, we believe most Committee members will view the growth outlook in an increasingly favorable light. Indeed, reflecting these considerations, we are increasing our own GDP growth forecasts for Q1, Q2, and Q3 by 0.25pp each (to +2.5%, +3.25%, and +3.0%, respectively; qoq ar).

Perhaps more importantly, inflation readings have firmed recently, and based on the Q4 GDP report, core PCE inflation likely ended the year a quarter-point above its August bottom. Of course, inflation still remains below target. But we think many Committee members will view the core inflation rebound in recent months as additional evidence that last year’s shortfall largely reflected temporary, idiosyncratic factors.

We also expect an upgrade to the balance of risks section, with the risks to the economic outlook changed from “roughly balanced” to “balanced.” In our view, the “roughly balanced” verbiage in the December statement was already somewhat stale, particularly when viewed in the context of the minutes’ upbeat growth commentary and risk assessment. Public remarks since that meeting bolster the case for an upgrade, and by our count, at least half of the Committee has recently referenced upside risks to growth. That being said, we expect the “closely monitoring” inflation language to remain.

Goldman is not alone in its concerns about a hawkish statement.  As Bloomberg notes, BofA, Credit Suisse and RBC say Fed may tweak description of market-based measures of inflation compensation to reflect recent move higher; economic assessment also “should get a slight mark-up from an already robust characterization,” RBC’s Michael Cloherty and Tom Porcelli say

Investors are still underestimating how much Fed could lift rates over time based on inflation, which along with other factors will push 10Y UST yield higher, according to Oliver Jones of Capital Economics.

Incidentally, for those keeping track, Market-implied odds of a hike are almost zero for Wednesday and 84% for March.

Here is what the rest of Wall Street thinks, courtesy of Bloomberg:

RBC (Cloherty, Porcelli, others)

  • While FOMC meeting might seem uneventful, statement will get important tweaks that make it “much more hawkish” than in December, including an upgraded assessment of household spending and less- dovish inflation language
  • “The market has been very sensitive to anything related to the inflation outlook,” and a change could get “a notable reaction”
  • A wild card is whether FOMC acknowledges some shift in balance of risks following passage of tax cuts

Credit Suisse (James Sweeney, others)

  • Fed is likely to keep fed funds rate target unchanged at 1.25%-1.5% and leave risk assessment as “roughly balanced”
  • “We do not anticipate meaningful changes to the statement,” yet wording on market- based measures of inflation compensation will likely acknowledge recent pick-up in inflation breakevens

BofA (Michelle Meyer)

  • Fed statement should send modestly hawkish signal as Jerome Powell prepares to take over as chair and more hawkish regional Fed presidents become voters this year
  • Policy makers will likely stay on path of gradual normalization, with three hikes each in 2018 and 2019 and risk skewed toward a fourth hike by year-end; BofA also sees risk that FOMC hints that fiscal stimulus can boost growth

Capital Economics (Oliver Jones)

  • Investors are underestimating how much Fed will hike, given likelihood of higher core inflation within months; this is a key reason why 10Y UST yield will rise
  • Other factors that may put upward pressure on yields include higher federal deficit as result of tax reform, shrinking Fed balance sheet, and tighter/less expansionary monetary policy outside the U.S.
  • “Although we are skeptical of claims that yields are about to surge, this all suggests to us that they will end the year a bit higher than they are at present”

Banque Pictet (Thomas Costerg)

  • Moderately hawkish hints that could be in FOMC’s statement include an upgrade of Fed’s outlook to “balanced” from “roughly balanced” and a mention of recent pick-up in market-based inflation expectations
  • Statement could also reflect the view that Fed is raising its expectations about impact of tax cuts on U.S. growth
  • Dropping any mention of the central bank monitoring global economic and financial developments would be another slightly hawkish sign

Deutsche Bank (Brett Ryan, others)

  • Statement will largely reinforce market’s pricing of three rate hikes this year, with next increase “all but certain to come in March”
  • Of this week’s data releases, personal income and consumption released Monday “will be foremost in FOMC members’ minds”
  • While policy makers won’t have January NFP data, they’ll get a sense of last month’s hiring trend with Wednesday’s ADP private employment survey; equally important will be Wednesday’s 4Q 2017 employment cost index

JPMorgan (Michael Feroli)

  • Statement should include upbeat economic assessment similar to prior two statements; reference to post-hurricane disruptions will probably be dropped
  • “We would be surprised if there were a mention of fiscal policy,” though there’s a hawkish risk that easy financial conditions will be mentioned
  • While one could make a case that risks are now tilted to the upside, FOMC will “choose the safe path” and leave balance-of-risks assessment unchanged; Fed hasn’t altered market’s expectations for quarterly rate hikes despite growth, inflation and financial conditions moving in a direction that calls for more tightening

MUFG (Chris Rupkey)

  • “The 800-pound gorilla in the room” of FOMC’s meeting is the market’s 80% odds of a March hike
  • It will be interesting to see if the Fed puts any “heads-up” language in statement about March; Powell is a “no nonsense lawyer” who may not favor such a “nod-nod, wink-wink”

Morgan Stanley (Ellen Zentner, Matthew Hornbach, others)

  • “We can hit the snooze button into the March meeting,” given data that’s largely in line with FOMC’s December outlook and markets already pricing in a rate hike in two months
  • No change in policy seen and “very little” change to the statement expected
  • TIPS market will see Fed’s acknowledgment of recent inflation developments “as a mere rubber stamp on already known information”
  • If Fed paints a more optimistic picture on inflation, front-end breakevens will widen and breakeven curve should flatten; however, this is “not our base case”

* * *

Finally, going back to Goldman, this is what a hypothetical, and redlined, hawkish January FOMC statement would look like according to the vampire squid:

Expected Changes to January FOMC Statement

Information received since the Federal Open Market Committee met in November December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Averaging through hurricane-related fluctuations, job Job gains have been solid, and the unemployment rate declined further remained low. Household spending has been expanding at a moderate rate strengthened, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year and are running below 2 percent. Market-based measures of inflation compensation have risen recently but remain somewhat low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricane-related disruptions and rebuilding have affected economic activity, employment, and inflation in recent months but have not materially altered the outlook for the national economy. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise maintain the target range for the federal funds rate to at 1-1/4 to 1‑1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

Voting for the FOMC monetary policy action were Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Patrick Harker; Robert S. Kaplan; Loretta J. Mester; Jerome H. Powell; and Randal K. Quarles; and John C. Williams. Voting against the action were Charles L. Evans and Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.