FOMC Meeting Takeaways: Why Inflation Risk Might Come to Bite the Fed

2. High for longer: rate hikes off the table, but cuts are not imminent either.

Another reason the Fed's message appears dovish is Powell's complete dismissal of rate hikes, suggesting the next move will likely be a cut, albeit possibly delayed due to persistent inflation and a strong job market. Powell stated, "So far this year, the data have not given us that greater confidence. In particular, and as I noted earlier, readings on inflation have come in above expectations. It is likely that gaining such greater confidence will take longer than previously expected," and "We are prepared to maintain the current target range for the federal funds rate for as long as appropriate."

While the Fed will have Q2 2024 data by July's FOMC meeting, which will occur shortly after QT tapering began, the Fed may want to wait until November to assess the economic impact of a slower QT before cutting rates. However, it's also possible that if inflation fails to trend towards 2% and the job market remains stable, the Fed may not cut rates throughout the entire year.

3. Is the Federal Reserve Monetizing the US debt?

Following the Federal Reserve meeting, it's impossible not to ponder whether the Fed is effectively monetizing US debt. The timing of the QT slowdown announcement, coinciding with the US Treasury's plans for increased issuance of coupon notes and bonds, raises questions. While reducing the volume of coupon-bearing securities exiting the Fed's balance sheet eases pressure on the long end of the yield curve and assists markets in absorbing the influx of Treasuries, it's important to note the inflationary implications of debt monetization.

Despite the initial market reaction post-FOMC, bond investors may reassess the fair value of securities, potentially demanding a higher inflation premium. Currently, this premium is elevated, a rarity seen only eight times since 1980. As the inflation premium rises, investors seek greater compensation for holding US Treasuries amid heightened inflation risks.

Anchored Front-Term, 5% on the Horizon for 10-Year US Treasuries.

The short end of the yield curve is expected to hover around 5% until clarity emerges regarding potential interest rate cuts. Consequently, the 2-year yield is projected to fluctuate between 4.75% and 5%. Any discussions of a possible rate hike by policymakers could propel yields above 5%, stabilizing them in the 5% to 5.25% range.

While the short end remains anchored, long-term yields may continue to climb due to several factors:

• Increased term premium: With rising inflation risks and market uncertainty, investors are likely to demand higher premiums to hold US Treasuries, exerting upward pressure on the long end of the yield curve.
• Elevated coupon issuance: Despite the QT cap reduction easing some pressure from substantial Treasury coupon issuance, the US Treasury is set to sell the highest volume of notes and bonds since 2022 this quarter, well exceeding pre-COVID averages from Q3 onwards.

Consequently, the long end of the yield curve remains susceptible to higher yields. A scenario where the 10-year yield reaches 5% before quarter-end cannot be ruled out.

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