Head of Fixed Income Strategy
Summary: A slightly more hawkish message at this week’s FOMC meeting is possible as voting Federal Reserve bank presidents rotate. A forceful Fed coupled with an increase in US Treasury coupon issuance will likely result in higher long-term yields. Yet, disinflationary trends, the end of the Bank Term Funding Program (BTFP) in March, and an increase in US Treasury coupon issuance are accommodating for upcoming less aggressive monetary policies. We expect a tapering of Quantitative Tightening to precede interest rate cuts. However, a review of the Fed economic projections in March might enable the central bank to bring both onto the table. That builds the case for a bond rally and bull-steepening of the yield curve in the year's first half. Yet, the real test will come in the second half of 2024, as inflation might remain elevated, resulting in the Fed lagging markets' rate cut expectations.
This week's FOMC meeting will see a rotation of voting Fed bank presidents. Chicago Fed's Goolsbee (dove), Philadelphia Fed's Harker (centrist), Dallas Fed's Logan (centrist), and Minneapolis Fed's Kashkari (hawk) will not vote in 2024. In their place, Cleveland Fed’s Mester (hawk), Richmond Fed’s Barkin (hawk), Atlanta Fed’s Bostic (hawk), and San Francisco's Daly (hawk) become voting members this year.
It is, therefore, safe to assume that the FOMC will be tilting hawkish at this meeting, especially when the new voting members have clarified their views before the blackout period. Loretta Mester recently said that a rate cut is “probably” too early in March, and Lorie Logan said that easing financing conditions put rate hikes back onto the table. More moderate are the views of Mary Daly and Raphael Bostic, who said that the economy and policy were balanced and that rate cuts might start earlier.
A stalling Fed coupled with an increase in US Treasury notes and bonds issuance means that we might be up for a bear-steepening of the yield curve, with 10-year yields rising towards 4.25%.
Yet, policymakers face tight financial conditions, with real rates remaining among the highest since the global financing crisis at 1.85%. As inflation continues to descend, the Fed runs the risk of tightening monetary policy further by just not doing anything, posing a threat to real growth in the coming quarters. That’s why, in December, the Federal Reserve signaled that rates have peaked and that cuts will start this year. The question is what inflation level will give the green light for the Federal Reserve to begin cutting rates.
While core CPI remains at 3.9% YoY, almost double the Fed’s 2% inflation target, the core PCE index dropped below 3% YoY for the first time in December. Regardless of the measure the Federal Reserve decides to look at, it will need to see clear disinflationary trends before engaging in easier monetary policies, making any signals to start cutting rates as soon as March is premature.
From the December Fed's economic projections, we know that the central bank expects real growth to fall to 1.4% in 2024, unemployment to rise to 4.1%, and headline and core inflation to fall to 2.4% this year and hit the Fed’s 2% target only in 2026. Such forecasts bode well with the December dot plot, which shows the Federal Reserve is in no rush to cut rates.
However, the picture becomes complete when considering Quantitative Tightening (QT). Economists estimate that QT was a substitute for roughly two interest rate hikes last year. If the Fed tapers the monthly amount running off from the Fed Balance sheet, a slower QT could serve as implicit rate cuts, adding to those already indicated by the dot plot.
Although we are not expecting any official announcement regarding QT this week, we do not exclude that the Fed might open to the idea that the runoff of its balance sheet is likely to decelerate. The central bank has already confirmed the end of the Bank Term Funding Program (BTFP) on the 11th of March and might be planning to slow down QT to ease financing conditions.
Remember that this quarter, the US Treasury is expected to increase borrowings further. Throughout the last part of 2023, the Treasury increased T-Bills sizes, which were easily absorbed by money market funds (MMF). Therefore, the Fed’s Reverse Repurchase facility (RRP) dropped to $570 billion from more than $2 trillion in the first half of 2023. If the Treasury continues to increase T-Bills issuance size, it will also start to drain reserves. Bank reserves at the Fed currently amount to $3.5 trillion, leaving some buffer to increase T-Bills supply, but not much. According to an August 2023 paper published by the St. Louis Fed, reserves are considered to be ample, around 10% to 12% of the nominal GDP, corresponding to around $2.7 trillion to $3 trillion bank reserves, as per the end of 2023.
As announced by the US Treasury in November, coupon issuance will need to increase this quarter. If QT is not slowed down anytime soon, there is a risk that upward pressure will be applied in the long part of the yield curve, causing financing conditions to tighten further.
That’s why we expect the Fed to tweak QT early and before cutting rates. The March FOMC meeting presents the perfect opportunity to do that together with a new set of economic projections.
For bonds, it will come down to where inflation will stabilize in the future and at what level the Federal Reserve will stop cutting rates.
Bond futures expect the Fed to cut rates at every meeting until September 2025, with rates bottoming at 3.5%. The 10-year US Treasury has historically offered a pickup of roughly 100bps over the Fed fund rate, implying 10-year US Treasury yields of 4.5%. Yet, the Fed dot plot shows a long-term neutral rate of 2.5%. The long-term rate of inflation will dictate where rates will stabilize in the future, making the long part of the yield curve volatile and likely to trade in wide ranges in the near term.
That doesn't mean that yields can't go lower in the meantime as disinflationary trends continue and the Federal Reserve declares victory over inflation, preparing to ease the economy.
Even if this week’s FOMC meeting happens to be hawkish or a non-event, the path for a bond rally is set in the first half of the year. The real test will come later in the year, as inflation might stabilize above the Fed's inflation target or even rebound, and the Fed might be lagging markets' rate cut expectations.
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