FOMC Preview

No one expects the Federal Reserve to change policy tomorrow. Those who expect a move this year are focused on the mid-December meeting.

The overall assessment of the US economy is unlikely to have changed significantly since the September meeting. It will be interesting to see how the Fed characterizes the labor market after two soft nonfarm payroll reports. However, other readings on the labor market do not confirm the deterioration. Specifically, the ADP estimate showed no marked slowdown in employment and the weekly initial jobless claims (four-week average) is at new cyclical lows.

Although many observers claim to be tired of a Fed move hanging over the markets, they will have to be patient for a bit longer. The Fed’s communication has shifted expectations from date-dependent to data-dependent. To rule out a December hike, which some observers anticipate, would seek to undo some of that necessary work. In addition, the Fed’s leadership has continued to suggest that, provided there are no new negative surprises and the economy evolves as officials expect, it still anticipates a hike before the end of the year. As there are two meetings left including this week’s meeting, it puts the onus on the December meeting.

There are three things we have encouraged investors to focus on when trying to assess the risks of a December move. First, listen to the Fed’s leadership – Yellen, Fischer, and Dudley. Dudley’s warning in August that a rate hike was less compelling was a good tell of the September disappointment. Second, watch the data on the US labor market. Like in Japan, the continued improvement in the labor market offsets much of the disappointment elsewhere. Third, watch the global markets. Global stock markets need not rise, but ideally the current relative calm will persist.

Given that the September FOMC cited market-based measures of inflation expectations as a factor in their decision not hike rates, one might be tempted to focus on the break-evens. The 10-year break-even (difference between the yield of a conventional 10-year bond and an inflation-linked bond) has firmed slightly since the end of September, but it struggles to sustain a move above 150 bp.

However, we suspect the Fed had decided not to hike in September and then found the reasons. As we noted, within a few days of the FOMC September decision, the San Francisco Fed released a paper that found that the break-evens were among the worst forecasts of future inflation. It will be interesting to see how the FOMC statement addresses inflation expectations. The survey based measures remain fairly stable.

The US dollar advanced sharply in the second half of last week following the dovish Draghi and easing by the PBOC. It consolidated those gains yesterday and today in Asia. A BOJ that does not increase its QQE could see a knee-jerk gain in the yen. The JPY120.35-40 area offers initial support. A break of JPY120 would be disappointing. The euro has posted some upticks after dipping below $1.10, which did not spur new selling. Euro gains could extend toward $1.1100-1.1125 before frustrating the bears.