Fed Meeting Presents Mild Asymmetric Risk of Higher Rates

By Simon Flint, Bloomberg reporter and commentator

There’s an asymmetric risk of U.S rates rising in response to Wednesday’s Fed meeting, given the extremely low current bond yields.

A baseline assumption would be for modest curve steepening if Powell remains dovish. However, it’s hard to identify sources of surprise, given Powell’s clear guidance from his Congressional testimony.

The key elements to look out for are as follows:

• Will the Fed punch the clock on taper? This seems unlikely, and consensus probably rightly expects the countdown — as so nicely outlined by Bill Dudley — to start at Jackson Hole and/or the September Fed meeting. That said, there may be a technical briefing from the staff concerning taper at this meeting. This could elicit questions at the press conference, and might harden perceptions that policy normalization is impending — although this should not be the baseline assumption

• If taper were to be brought forward, it would be in response to the continual upside surprises to inflation — not just in the headline figures, but in the increasing concerns expressed by the Beige book. However, it seems highly likely that the Fed will continue to characterize the inflation shock as transitory

• This is not least because the labor market is likely to become a greater drag on prices in 4Q. As Bill Dudley has said; the factors leading to labor market tightness are themselves mostly transitory — being related to the government and public response to Covid-19, and as “they abate, the labor market is likely to loosen.”

• Furthermore, it seems highly likely that Powell will be asked about risks to the recovery from the delta variant, if a reference is excluded from the policy statement. Chiefly this should be characterized as a further downside risk to the recovery. Although it’s worth remembering that supply-side disruptions could cause further inflation pressure that currently envisioned, these are unlikely to be sufficiently persistent

• Relatedly, the main mechanism for these transitory shocks to become entrenched would be through inflation expectations, which the Fed should address at this meeting. The most recent readings suggest that expectations are unthreatening

• Powell may be asked about very low bond yields at the press conference. I think that he’s likely to suggest that the overall very loose financial conditions are conducive to recovery, although some commentary I have read suggests that he’ll view this as validating the Fed’s cautious approach to policy normalization

All-in-all it’s hard to point to a clear market catalyst from the upcoming meeting. However, with the curve so flat, the bias should be for some steepening. Beyond that, the hawkish tail seems fatter and longer than the dovish tail risk.