Little chance of a FOMC rate hike today
ADP employment expected to remain strong
Treasury refunding announcement may boost 10-year and 30-year auction sizes
Little chance of a FOMC rate hike today — There will be no press conference following today’s conclusion of the 2-day FOMC meeting. This will be Janet Yellen’s last FOMC meeting since Jerome Powell will take over as Fed Chair this Saturday (Feb 3). The markets today will be watching mainly to see if the FOMC in its post-meeting statement turns a bit more hawkish in its assessment of the economy, inflation, or interest rates.
The federal funds futures market is discounting only a 20% chance that the FOMC today will raise its funds rate target by another +25 bp. The FOMC just raised its funds rate target range by +25 bp to 1.25-1.50% at its last meeting on Dec 12-13, meaning it would be too soon for another rate hike. However, the market is discounting a 100% chance for the first +25 bp rate hike of the year at the next FOMC meeting on March 20-21.
The market is currently expecting +66 bp worth of Fed rate hikes this year, according to the federal funds futures market. The market is therefore expecting only about 2-2/3 rate hikes this year, which is slightly less than the Fed-dot forecast for three rate hikes totaling +75 bp.
We expect the FOMC to make good on its forecast for three rate hikes this year, which would suggest that the market is still underestimating the Fed’s rate-hike potential for the year. To the extent that the market is underestimating the Fed’s rate-hike potential, the 10-year T-note yield likely has more room to rise as the year wears on.
We believe that the Fed is chomping at the bit to get the funds rate target above 2% in order to do away with the negative real federal funds rate seen for past decade. A negative real federal funds rate fuels asset bubbles and excessive risk-taking and is no longer necessary given the synchronized global economic expansion, the strong U.S. labor market, and stable credit conditions.
If the Fed makes good its forecast for three rate hikes, the funds rate would rise to 2.00-2.25% by year end, i.e., slightly above the Fed’s 2% inflation target. Once the funds rate is above 2%, then the Fed can take its time on raising the funds rate further to the terminal rate near 2.75-3.00% in order to avoid overdoing its tightening and causing a recession.
The market is not expecting the FOMC today to make any adjustment to its balance sheet reduction program. The program started off with a maximum drawdown of $10 billion per month in Q4-2017 and is currently at $20 billion per month in Q1. The Fed has already announced that the maximum drawdown will rise to $30 billion in Q2, $40 billion in Q3, and then reach its maximum value in Q4 of $50 billion. The program is currently open ended with no termination date or final balance-sheet target level.
Fed officials have so far been correct that the balance sheet reduction program has been like watching paint dry. The Fed’s current balance sheet level of $4.441 trillion is down by a barely perceptible -$14 billion from the pre-program level in late-Sep 2017. However, the Fed’s balance sheet will drop more quickly as the year wears on, thus draining reserves and adding to the tightening effect from the Fed’s expected rate hikes.
ADP employment expected to remain strong — The market consensus is for today’s Jan ADP employment report to show an increase of +180,000. That would be a strong level, although down from Dec’s strong report of +250,000 and the 12-month trend average of +212,000. On the labor front, the markets are mainly looking ahead to Friday’s Jan payroll report, which is expected to improve to +180,000 from Dec’s weak report of +148,000.
The markets will be watching today’s ADP report and Friday’s payroll report to see if December’s weak payroll report of +148,000 hinted at some impending labor market weakness. However, the weak Dec payroll report was likely due to one-off factors and payroll growth is likely to return to trend in 2018 due to business optimism stemming from the large business tax cuts.
Treasury refunding announcement may boost 10-year and 30-year auction sizes — The T-note market is wary about today’s Treasury refunding announcement. The Treasury faces a larger financing requirement in 2018 due to a rising federal budget deficit and the Fed’s balance sheet reduction program. The Treasury is therefore expected to raise the size of its auctions, mainly on the shorter end of the curve.
The question is whether the Treasury will extend those increased auction sizes to the long-end of the curve. The consensus is that the Treasury in today’s refunding announcement will either leave next week’s 10-year and 30-year auction sizes unchanged from November or increase them each by $1 billion. The Treasury at its last refunding operation in November sold $24 billion of 3-year T-notes, $23 billion of 10-year T-notes, and $15 billion of 30-year bonds. Larger 10-year and 30-year auctions next week would add to the bearish tone in the Treasury market.
EIA report — The consensus is for today’s weekly EIA report to show a +700,000 bbl increase in crude oil inventories, a +2.0 million bbl rise in gasoline inventories, a -250,000 bbl drop in distillate inventories, and a -0.5 point drop in the refinery utilization rate to 90.5%. Today’s expected increase in crude oil inventories would be the first increase in 10 weeks. Crude oil inventories have plunged by 124 million bbls (-23%) from March’s record high. Crude oil inventories are now only +5.0% above the 5-year seasonal average, the tightest such level in more than 3 years.