Bond and currency traders on Wall Street are focusing on how the Federal Reserve will factor pending legislative moves, like tax cuts, in their policy measures, according to market participants.
Traders and strategists are expected to keenly watch for references to fiscal stimulus and the threat of market volatility next year in its updated policy statement, which could influence Treasury and dollar-pair trades.
Wall Street is pricing in near certainty of a quarter-percentage point increase to benchmark interest rates at the conclusion of the Fed’s meeting on Wednesday, which will be the penultimate one for outgoing Chairwoman Janet Yellen, as Fed Gov. Jerome Powell is set to replace her next year.
Both the U.S. dollar, which has ticked up since hitting a year-to-date low in September, and the flattened Treasury yield curve reflected how widely the move is anticipated.
That said, the unlikely downside risk of a surprisingly dovish Fed, would send the buck and bond yields all swinging wildly, market participants said.
Read: Here’s why the Fed will hike interest rates
There was a lot of uncertainty around the U.S. tax reform and its ramifications for monetary policy, as well as the change of the guard at the Fed after Yellen’s departure, which could dampen expectations for changes in the so-called “dot plot”, the Fed officials’ forecasts for interest rates, said Ward McCarthy, chief financial economist at Jefferies.
“Precedent suggests that FOMC participants will likely update their projections to partially reflect the impact of tax reform, though the full impact—especially on the rate projections—will likely come later,” according to a note from Goldman Sachs published on Friday.
“While we expect four rates hikes next year, we think it’s premature to expect the median dot at end-2018 to move up from three,” the note said. Roughly half of the three predicted rate hikes are currently priced in, according to HSBC FX strategists David Bloom and Daragh Maher.
Bond and currency markets could see increased volatility if there were any changes made to the dots. Since the last time the Fed’s projections for interest rates were released on Sep. 20, the 2-year Treasury yield TMUBMUSD02Y, +0.45% rose more than 50 basis points to 1.81% and the ICE U.S. Dollar Index DXY, -0.15% which measures the buck against a half-dozen major currency rivals, has strengthened somewhat. The move in Treasurys has helped lead to a compression in the yield gap between short-term maturities and long-dated ones, narrowing the gap, or flattening the yield curve, as it is often described.
Given all the unknowns, this could mean a change for the Fed’s forward guidance, which has informed trading in the past and has become a de facto policy tool of its own.
One reason the so-called dot plot could shift higher is the recent improvement in readings of inflation. Stubbornly low inflation has been on of the Fed’s biggest bugaboos, hovering below its 2% annual target, considered an appropriate level in a healthy U.S. economy. Charged with the mandate of price stability, the Fed tends to move its rate-hike forecasts in line with their expectations for inflation.
A combination of rate hikes and low inflation have stoked worries of a policy misstep by the Fed that could result in further flattening, or an inversion, of the yield curve. An inverted yield curve, where short-dated yields are higher than their longer-dated counterparts, has often been viewed as a precursor to a recession.
Recently, however, core consumer-price data, which strips out the more volatile oil and food prices has improved, leading to some speculation that the Fed might ramp up its pace of rate increases. Core CPI edged higher to 1.8% year-over-year in October after hitting its midsummer lows.
In fact, some analysts are anxious that inflation may accelerate too quickly in 2018, leading the central bank to raise rates more aggressively than it would prefer. Yellen said the Fed should gradually raise rates to avoid rattling markets.
The Fed’s efforts to provide guidance has taken some of the drama out of central bank decisions, HSBC’s Bloom and Maher said in a note on Monday, adding that it also reduced volatility, for example in the foreign exchange market. Now, however, forward guidance might lose its ability to send a clear message to the market.
“If the internal consensus within the Fed begins to wobble, providing meaningful forward guidance becomes problematic,” Bloom and Maher wrote, saying that this could prevent clarity and cause the Fed-funds rate to move up to a level where there is less consensus that it should rise much further.
“If the Fed, due to the data releases and hike already in place, becomes less confident about the path of future policy then the forward guidance will become either less strident, more opaque, prone to change or less accurate,” they wrote. “This could be one of the catalyst to reintroducing volatility to a low volatility world.”
That could mean the gradual pricing in of policy action could be exchanged for more pronounced reactions by markets.