FOMC preview: An early test for Warsh

While the base case remains the Federal Open Market Committee will hold rates in a range between 3.50% and 3.75%, a 25-basis-point hike could be on the table this week as bond market fundamentals have deteriorated, analysts said.

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While inflation numbers were tame and jobs grew moderately since the panel last met, “those positive trends were thrown for a loop in July as the military conflict with Iran escalated,” said James Ragan, co-chief investment officer and director of investment management & research at D.A. Davidson.

The renewed hostilities and disruption of traffic in the Strait of Hormuz sent oil prices higher, he noted. “This means that some of the June inflation gains, at the headline level, are likely to reverse and the Fed must assess if inflation trends are more durable at the core level.”

Fed Chair Kevin Warsh has vowed to control prices.

“If the Fed determines that higher inflation expectations are becoming embedded, they should act (raise rates) in July, rather than waiting until the next meeting, which is not until Sept. 16,” Ragan said, especially with midterm elections that will make action later this year open to criticism of politics.

“For that reason, if the Fed is close (on the fence) in July, it might prompt the committee to act sooner rather than later,” he said.

Treasury bond yields have risen since the last Fed meeting in June, with the 2-year yield at a 17-month high, and the 10-year at an 18-month high, Ragan said. “In our view the 2-year Treasury yield, with some lag, can be an accurate predictor of future Federal Reserve interest rate changes. The midpoint of the Fed’s current fed funds target range (3.50% to 3.75%) is 3.63%. The 2-year Treasury yield is 4.33%, 70 basis points higher. This suggests that bond investors see the possibility of nearly 0.75% of rate hikes (perhaps in increments of 0.25%) over the next several months. This also suggests that the bond market believes that the Fed is already late in its tightening cycle. If rates continue to move higher, pressure on the Fed will mount.”

The 10-year’s yield increase “is more complicated,” Ragan said. “It could reflect an investor view that inflation trends will remain higher for longer, but the 5-year breakeven rate (market estimates of inflation after 5-year) published by the Federal Reserve Bank of St. Louis, remains well below levels of a couple of months ago.”

Rising long-term yield could be related to the growing national debt, he added.

“New Fed chairs often face unexpected monetary system challenges and bond investors want to be reassured that the Fed will be serious about addressing those challenges,” Ragan said. “The bond market could cheer a Fed rate hike next year, as a proactive inflation-fighting measure. On the flip side, we could see Treasury yields move even higher if the Fed chooses to hold fed funds rates unchanged once again.”

Paolo Zanghieri, senior economist at Generali Investments, is looking closely at the Fed’s messaging. The FOMC will “maintain — or even strengthen — a hawkish tone as persistent inflation, rising oil prices and divisions within the FOMC keep the door open to further tightening later this year.”

Wells Fargo Investment Institute expects the rate target to remain, said Paul Christopher, its head of global investment strategy. “The inflation respite in June gives policymakers an opportunity to extend their rate pause and await more data now that the Iran war has resumed.”

Luis Alvarado, WFII co-head of global fixed income strategy, noted Warsh has clearly stated “bringing inflation back to 2% remains the Fed’s top priority, and policymakers have little tolerance for a resurgence in price pressures. In our view, he does truly believe the Fed can accomplish this objective.”

The biggest change Warsh may bring is in communication, especially in forward guidance, Alvarado said. “Investors should expect greater policy flexibility and potentially more market volatility between meetings. Optionality to act and react as conditions change remains paramount to the new Fed chair,” he said.

Additionally, Warsh declared one good inflation report doesn’t signal victory, “In other words, mission is not accomplished, far from it and the work to get there is underway,” Alvarado said.

While Warsh is likely to offer limited communication, “The good news is, there’s a way to understand how the Fed will react without being spoon-fed forward guidance,” said FHN Financial Economic Analyst Mark Streiber. “After all, we still understand how the Fed interprets inflation and labor market data, and (at least for now) we still have the dot plot.”

But the temperature of the panel is unclear, he said, “as many FOMC officials have not commented on monetary policy in months.” Those that did mostly relayed a desire to hold rates, although “Kansas City’s Jeff Schmid and Dallas’ Lorie Logan who both think a rate increase is warranted sooner rather than later.

“Even if rates are left unchanged, as expected, the tone of the statement and press conference — Warsh would not commit to one when asked in June, but there is a press conference scheduled on the Fed’s website — is likely to remain as hawkish as in June,” Streiber said.

Some officials will want to see more positive inflation news before changing rates, he said. “All signs point to a wait-and-see meeting where the Fed leaves rates unchanged, with even less information in the statement and presser to trade on than in June.”

Gary Pzegeo, CIO of CIBC Private Wealth US, said, “Warsh’s tough talk on price stability and a batch of soft data (the consumer price index and non-farm payrolls) may be enough the keep the Fed on hold.”

This coincides with market sentiment. “Interest rate futures are pointing in a sideways direction for the July meeting,” Pzegeo said. “Expectations have been rising, however, for a September rate hike. September is an eternity in the current geopolitical context, and the Fed will have much more data to process between now and September 16.”

BNP Paribas Markets 360 team expects the Fed to hold rates, “although a shock rate hike can’t be ruled out entirely.” Its base case is one hike this year in December, with “a significant risk that policymakers intensify language around inflation in the FOMC statement, tacitly signaling that a hike is on the table for September.”

The language related to price stability will be the major debate at the meeting, BNP said, with a stated willing to act when needed.

But the “absence of such language” would not rule out a September rate hike nor would its inclusion guarantee a hike in September, they said.

“At his press conference, we expect Warsh would broadly follow a similar template to June: a short opening statement, succinct answers, and very limited forward guidance. Assuming the statement is little changed from June, we think the opening statement would closely follow Warsh’s congressional testimony, as would Warsh’s characterization of the inflation and labor data, the economic outlook, and his commitment to restore price stability,” BNP said.

Joe Kalish, chief macro strategist at Ned Davis Research, expects a hike by September, which “puts this week’s meeting firmly in play.”

With the market already pricing in rate hikes this year, Kalish asks, “why wait?” A hike would “cement independence” and “enhance Fed credibility,” he said. But he noted, there are reasons to hold rates, including the latest inflation figures and well-anchored inflation expectations.

“If the Committee or Chair Warsh offer even an inkling of guidance, they likely will indicate that the decision between holding rates steady or hiking in September will be data dependent,” noted Bill Adams, chief U.S. economist at Fifth Third Commercial Bank.