Head of Fixed Income Strategy
Summary:
- Before the FOMC meeting, the focus will be on CPI data for the 3-, 10- and 30-year auctions. Demand for duration amid disinflationary trends will be tested on Tuesday.
- The federal fund rate is likely to be left unchanged at 5.25%-5.5%. Still, the revision of the Federal Reserve’s summary of economic projections (SEP) and the dot plot will be a critical focus.
- An upward revision in growth due to a faster disinflationary trend could fuel further speculations of a soft landing, but it will also put at odds markets’ expectations of five rate cuts in 2024.
- A lower dot plot and lower projected inflation will likely consolidate the recent bond rally.
- In the coming months, the Federal Reserve needs to move towards cuts quickly to justify current bond future valuations, and that will unlikely happen, putting upward pressure on yields.
- Significant pre-emptive rate cuts are unlikely amid supportive fiscal spending.
Although the Fed fund rate is likely to be left unchanged, the FOMC December meeting will certainly not be dull.
Markets are pricing 125 basis points rate cuts by the end of next year as investors are fast to claim that inflation is dead. However, the FOMC September dot plot shows that policymakers expect to cut rates only twice next year, making the divergence between markets and the Federal Reserve's projections the perfect volatility cocktail.
Despite such a dramatic divergence in rate cut expectations, economists are somewhat aligned with the FOMC summary of economic projections (SEP) for the next few years. Indeed, core PCE is expected by the end of next year at 2.7% by economists surveyed by Bloomberg and at 2.6% by the SEP. Similarly, real growth and the unemployment rate are expected at 1.5% and 4.1% according to SEP and around 1.2% and 4.3% by economists.
Yet, the Fed might be looking to update some of those projections. In October, the core PCE price index was up 3.5% YoY, well below the 3.7% the Fed estimated to end the year with. At the same time, the October unemployment rate has risen to 3.9%, well above the unemployment rate expected by the central bank at the end of 2023.
That should lead the Fed to revise inflation down and unemployment up, agreeing with markets' view that there is no reason to hike any further, fueling discussions concerning when interest rate cuts will begin and by how much.
Yet, it’s uncertain what the SEP will show in terms of real growth projections. Seeing a faster disinflationary trend than anticipated might lead to an upward revision in growth, fueling speculations of a soft landing. That might be enough to put at odds market expectations of five rate cuts next year, besides the dot plot.
The FOMC dot plot will be the market's big focus. The median rate cuts expected for next year and 2025 will likely shift further down. However, considering that in September, only five members were showing a rate of 4.625% or below by Q4 2024, it is unlikely that we are going to see other members lowering their expectations below that threshold, making the Q4 2024 median rate more likely to remain between 4.8% to 5%.
Although the gap between policymakers and bond future markets' expectations of rate cuts will remain wide, a lower dot plot combined with lower projected price pressures will likely consolidate the recent bond rally.
The real challenge for bond markets will come in the next couple of months when central banks need to move towards cuts quickly to justify current bond future valuations.
Central banks are unlikely to deliver aggressive rate cuts pre-emptively for the following reasons:
That’s why, as central banks have fought to significantly tighten the economy amid a dangerously high wave of inflation, they will only move once they have the certainty of having fixed this problem. Otherwise, they risk entering stagflation, a period of high inflation and high unemployment, which is a much more challenging scenario to deal with, especially during an election year.
Next week is not going to be all about the Fed. Markets will have to weather a double auction on Monday, with the US Treasury selling three- and ten-year US Treasury, a thirty-year auction, and CPI numbers on Tuesday.
The 10- and 30-year US Treasury auctions will be the main focus, as after the dramatic drop in yields, buying longer-term bonds has become most expensive since September. After witnessing an ugly 30-year US Treasury auction last month with primary dealers taking 24.7% of the issue, the largest share since November 2021, the question is whether investors will step in this time when the yield on the 30-year tenor is roughly 50bps lower than last month. Weak bidding metrics in the 30-year tenor might reignite the bear steepening of the yield curve.
To set the grounds ahead of the 30-year auction is a new set of US CPI data. While the headline CPI is expected to have dropped to 3.1% YoY in November from 3.2% in October, Core CPI is expected to have remained flat at 4%. While it is true that if numbers show a faster disinflationary trend that would be bullish for bonds, it's key to bear in mind that it is more likely for an auction to tail if a considerable drop in yields precedes it. Yet, the magnitude of such a tail will dictate whether investors see it or not as a sign of fiscal dominance, as well as the constraints that the US Treasury has in raising additional new debt in markets. Let's remember that the US Treasury was meant to sell $38 billion in 10-year notes and $22 billion in 30-year bonds next week, according to suggestions from the Treasury Borrowing Advisory Committee TBAC. Yet, due to weaker bidding metrics, the Treasury has decided to play it safe and sell $1 billion less than what was suggested.
Suppose the US Treasury happens to follow the suggested increases in US Treasury notes and bond issuance in the first quarter of 2024. In that case, the auction size will rise to a record high, even above what markets used to absorb amid the COVID pandemic when quantitative easing (QE) was a supportive force for markets.
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