- Yesterday, 17:33
- Rates Spark
On the Fed, it's tough to view the current set-up of still elevated printed inflation and a Fed on hold as all that protective. We glean from this enough to validate the move back above 5% on the 10yr. On the ECB, forward guidance on policy rates is likely of secondary interest compared to questions about France or minimum reserve requirements
The lean hawkish is enough to validate the break back above 5% for the 10yr
Hardly a word in the short Fed statement that did not lean hawkish. But no hike. Prior to the FOMC meeting, it was remarkable how the 10yr yield had been clinging to the 4.99% level. It was like a comfort level; technically below 5%, but not too far below in case it needs to turn tail and shoot back up. It seemed that the US 10yr was waiting to tick off this outcome before deviating too much from 5%. Well, it’s now had the outcome. The initial reaction was up. But the reaction to Chair Warsh’s words at the press conference was to move back down to 5%, and briefly below. This can be rationalised by Warsh’s comforting words on inflation expectations, which he deemed to have been tamed somewhat.
That all being said, our interpretation is that this Fed still has a job to do if the type of price stability that Chair Warsh has described is to be achieved. He has described price stability as strictly 2%, and he seems to be serious about hitting that. This is good from a protective sense for the back end. At the same time, it’s tough to view the current set-up of still elevated printed inflation and a Fed on hold as all that protective. Also, inflation expectations in fact rose post the Fed decision and subsequent Warsh commentary. We glean enough from this to validate the move back above 5% on the 10yr. We maintain our view that we’re on a journey back up in the direction of 5.25%.
The front end of the curve took the tone from Chair Warsh better, with the 2yr yield edging lower. What the front end likes is the no change from the Fed, and the idea that the Fed is giving the economy time to fully react to the first 25bp rate hike. There is a world here where this Fed might not be as aggressive as it is pretending to be through its words, as the actions so far are just one 25bp hike. The net outcome is a steeper curve from both ends, and we suspect we'll see some more of that in the weeks ahead.
The implementation note was broadly unchanged in terms of action. The various implementation rates are unchanged, as are the implementation mechanisms. And the Fed will continue to reinvest principal payments from its MBS securities into Treasury bills. We’re likely still some way from the Fed spelling out a plan to shrink its balance sheet, which we know remains a policy objective for Chair Warsh. We expect recommendations from the various committees to surface closer to the turn of the year. Meanwhile, liquidity conditions are stable, with repo behaving far better than it did a year ago.
Questions for Lagarde on France should be of more interest than rate decisions
The European Central Bank will decide on its monetary policy on Thursday, but no one is realistically expecting any change in interest rates. On the topic of rates, the focus will be on the wording surrounding a potential rate hike at the December meeting. Here, markets are already discounting 23bp of tightening.
Lagarde will face more questions around the situation in France and what the ECB could do to contain the bond market turmoil. We have written about the sequence of actions that the ECB will likely follow, verbally toning down hawkishness first, before more direct intervention by suspending quantitative tightening and resuming reinvestments and eventually, if that fails, activating the Transmission Protection Instrument. While we might already have seen instances of the first, the hurdle for the next steps appears very high. No doubt, Lagarde will still be asked about it.
Amid the bond market turmoil, the debate about whether the ECB should increase banks’ minimum reserve requirement – mainly to reduce its own costs stemming from quantitative easing – has taken a back seat. As was the case when this discussion first arose, we think the same arguments around it being too blunt a tool for that purpose still apply. And this time around, excess liquidity levels already appear closer to levels where larger changes could start to impact financing conditions more noticeably. With plenty already going on, we doubt the ECB would want to add more volatility to the system.
Overall, while markets will listen carefully to Lagarde, we don’t expect this week’s meeting to trigger a major repricing. A stronger commitment to a December hike would nudge a hawkish repricing, but with more than 20bp already priced in, the reaction should be contained.
Thursday’s events and market views
The ECB meeting is the main event, but we also have multiple data releases to watch. The US will publish PCE numbers for September, with consensus expecting a relatively hot 0.3% month-on-month core reading. US GDP numbers for the third quarter are expected to show a resilient outlook with 3.2% annualised growth pencilled in. The eurozone will publish confidence indicators, which should soften slightly on the back of higher energy and borrowing costs.
Italy will auction 5y BTP, 7y BTP, 10y BTP and 10y CCTeu for a total of €7.75bn. Finland has ORIs, while the US will auction $44bn of a new 7y note.
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