BNY Mellon: The Aerial View: November FOMC: Fed Carries on with Gradual Tightening

Nov 9, 2018

By John Velis, FX and Macro Strategist, Americs, BNY Mellon

Not unexpectedly, the FOMC’s November meeting offered little change to market perceptions on its policy path or its characterization of what it thinks are the key issues pertaining to its outlook.

Gradual tightening remains the operating principle. Market odds of a December hike remain in the high 70s, where they have been since mid-September.

This “soft” pledge will solidify the notion that the Fed is the hawkish outlier in a world of G10 central banks, and add some lift to the USD.

We maintain that while carry per se is not driving medium-term FX movements, relative policy expectations have been.

The chart below shows the DXY Index against a “policy divergence proxy”. The latter compare the difference between the longest-dated interest future available and the 1Y1Y forward bond yield in the US against the same for a combination of other G10 currencies.

Policy divergence remains stable (i.e. relative expectations for central banks around the world have not changed very much in the last several weeks), as does DXY – for now.

The only material change to the accompanying statement was a change in how the Fed described business capital expenditure.

The last statement celebrated CapEx as having “grown strongly”, while this month CapEx “moderated from its rapid pace earlier in the year”. This is not the Fed’s opinion - rather it is a dispassionate description of the facts.

There had been some curiosity that the Fed might discuss changing its policy on the Interest Rate on Excess Reserves. This is a relatively new policy tool adopted by the Fed to keep the effective Federal Funds Rate below the upper limit of the FFR’s target range.

With the balance sheet being drawn down, changes in IOER induces banks to choose between accruing interest from the Fed on its Treasury securities portfolio or lending those securities out in the interbank market.

A sufficiently low IEOR would make lending in the Federal Funds market more attractive to banks. Lately the effective FFR has been drifting close to the top of the target range, prompting market participants to question why.

Is the IOER too high, forcing Federal Funds higher as a competing asset? Or is the balance sheet roll down due to the end of QE (combined with massive Treasury issuance in Q4 this year) flooding banks with USTs, making their price lower and yields higher? The Fed offered no opinion on this question, nor did it discuss IOER at all in the statement.

That doesn’t mean it was not discussed during the two-day meeting this week, and it does suggest that if the effective FFR does not settle back down to the middle of its target range, expectations that the Fed will address it will be high.

Between this, the expected hike priced in for December, new forecasts and dots, and a press conference the week before Christmas, all promise to offer a spiked bowl of eggnog at your company’s holiday party.