Macro Digest: Why the Fed is more likely to pause today than hike.

What: Tonight’s FOMC meeting
Consensus: +25 basis points (85%+ probability priced)
My call: No change (75% probability)

Disclaimer: I have no special insight, just trying to weigh as many variables as possible here. The bottom line is that the Fed may decide it is preferable to pause now and then either resume hiking if financial conditions calm quickly since inflation is still a pressing concern, or quickly start cutting if conditions deteriorate badly and the economy is seen at risk. More embarrassing to hike now only to have to quickly pivot later.

The arguments in favor of hiking 25 basis points:                                   

• The ECB last week did well to stay focused on inflation credentials, which was again confirmed in a speech from President Lagarde this morning, by the same token Fed Powell could use this “model”, even if his hand is weaker as ECB didn’t have any bank troubles, Powell does and the fundamental problem of securing 4,300 regional & local bank in the US is now political and always has been.
• If there had been no banking crisis, Fed would have hiked 50 bps tonight – 25 bps is compromise and if it comes with signal of “pause” – it probably has the right balance of “stepping down” when also reinforced with a clear signal of FOMC moving to pause if trouble continues. Market could interpret this as Fed saying: “We are data dependent....But we also have “data patience”.
• Inflation remains high despite energy being on the low. Any mean-reversion going forward on energy would increase likelihood of sticky inflation for long. (Comment: Technically an interesting “Hammer” has formed in oil charts yesterday and Brent is at least 5$ below 80-100 $ range expected by commodity traders and the net demand increases seen from China)
• Tactically there is no doubt that that delivering what the market expects is assumed to create the least room for interpretations of why the Fed surprised. (Comment: No one knows!!)
• The baseline is important (H/T: MG) Pre-crisis we were at nearly 5.75% for the Fed terminal rate. The market is now under 5.00 and December is priced at below 4.50%, i.e., for cuts. In order to get these cuts, credit conditions would need to be 25% worse than they are now (they are poor already) – Meaning on fair valuation, the market has priced too much in the forward curve and delivering +25 bps would off-set some of that and send the right signal to the market.

Arguments in favour of a Fed pause today:

• The market is pricing 50 bps (2 Fed cuts) between peak rates at this meeting or next and December 2023. Why would FOMC move rates up only to have to do embarrassing U-turn at the next meeting (Mind you the US short-end moves rates up +/- 50 bps every three hours over the last week or the equivalent of 2 FED cut/hikes, so why should we give this any credit?)
• Regional and local banks are critical to the US economy. The US is unique in its banking structure needing 4,300 banks to service rural America. These banks are as much as 150-175 years old and a central instrument for keeping local America financed and growing. This means political capital is behind these banks and as such they are “untouchable”. This means Powell will need to back Treasury Sec Yellen on blanket support for deposits well knowing such a scheme has no chance in passing Congress. This is not only about political capital but also about “market functioning”. The fact is money is still leaving regional banks in size.
• Going to pause directly is far more credible than hiking now only to cut next time. The outside risk is a +25 bps would be similar to Trichet’s hike into the 2008 crisis (considered the worst central move ever anywhere – but of course employment was much worse then) – tactically zero is the right medicine in times of uncertainty. The truth is no one knows if Fed in 18 month have hiked 100-150 bps or cut them by same amount!
• Finally my 4-Factor Models: Monetary indicates that if the Fed hikes, it will make things worse: The 4-factor model on monetary is neutral on financial conditions. We are exactly at the average for the last year. Bond volatility is trading in the fourth quartile: Index 80 is the long-term average expected and the 12-month average is index 126: we are at 162 despite “calm” returning over last 48 hours) This favors no change. Dollar Index: neutral. FED next 18 months – indicates 109 bps of cuts. This is low of the last 12 months and favors cuts.