FOMC Preview: Powell expected to deliver dramatic shift to easing

Today’s stock market rally that was driven on Trump’s optimistic trade tweet and expectations central banks globally are on the verge of delivering more stimulus. US equities and global bonds soared early on the prospects that the US-China trade war could see a return of constructive dialogue and on stimulus hopes from the ECB and Fed. Markets were strongly reacted to Draghi’s speech that signaled the ECB is almost ready to add stimulus. The euro dropped against the dollar following Draghi’s much to the chagrin of President Trump.  The US President noted that the ECB is making it easier for Europe to compete against the US.  Trump also reiterated criticism of the Fed, also attempting to pressure the FOMC to deliver rate cuts.  In February, the White House explored the legality of demoting Fed Chairman Powell.  The Fed’s nonpartisan independence is important, but with the recent run of data deterioration, when they capitulate, President Trump is certain to take a victory lap in saying he was right that they needed to cut interest rates .

– Fed to drop ‘patient’ stance
– First time dot plots to show rate cuts
– Next move could be a 50-basis point cut

The Federal Reserve will conclude its two-day policy meeting with economists expecting a confirmation of an easing bias in the second half of the year. Fed fund futures see a 22.9% chance that rates will be cut at tomorrow’s meeting, while the July 31st meeting have an 83.0% expectation for a rate cut. The data dependent Fed will only have to look at their first regional survey, Empire Manufacturing which saw its worst decline on record. Broad weakness has started to hit the US economy from trade uncertainty and that should still persist even if Trump and Xi deliver a de-escalation in tariff threats at the G20 summit at the end of the month. The Fed could try to hold out one more month before committing to rate cuts and note that the policy stance is appropriate right now. The dollar could rally if the Fed reiterates their patient stance, but the more likely scenario is for Powell to begin to adopt a dovish stance. How dovish of statement and how many rate cuts are shown in the dot plots will likely determine how far the dollar could fall.

Dot Plots

If the Fed does not surprise markets with a rate cut, investors will quickly look to see how the dot plot forecasts are updated. Each quarterly meeting the central bank will show what each policy makers’ expectations are for interest rates over the next few years. The last update in March saw 11 of the 17 FOMC officials expected rates to remain on hold for the rest of the year, while four expected a 25-basis point increase and two expected interest rates to rise by half a percentage point.
This will be the first time the dot plots are being updated to what is expected to be interest rate cuts and not hikes. Historically, the rate projections have only been used to show a gradual path of increases, so markets will closely watch how dovish each member becomes.

How Big will the first cut be?
With markets preparing for the Fed to begin an easing cycle, many will look to see if policy makers are opting for a half-percent move over a quarter point adjustment. When beginning an easing cycle in both 2001 and 2017, the Fed decided to surprise markets with a 50-basis point cut over a quarter point adjustment. The argument for a steeper rate cut stems from the recent success with market impact in delivering a stronger dovish signal. Fed officials may lose this surprise however if the dot-plot forecasts prompt investors expectations.
Economists mostly agree that the December rate hike was a policy mistake and if the Fed wants to send a clear dovish message, a half a percentage point cut in July could do the trick.

Inversions
The yield curve inversion between the 3-month and 10-year yields has been inverted for 19 straight day, currently at 14.7 basis points. The 10-year and 2-year spread, which has yet to invert in this cycle has narrowed to 19.18 basis points. The 10-year yield on Treasuries continues to slide and is approaching the 2.00% level, which is well below the current Fed Funds target range of 2.25-2.50%. A Fed rate cut will help the current strain on bank lending which heavily relies on the 2-year and 10-year yield curve.

Draghi
Bond markets soared after ECB Chief Mario Draghi reminded investors the bank could provide additional stimulus via rate cuts or asset purchases if the outlook does not improve. Since the inflation path is converging more slowly than expected, financial markets are now targeting fairly confident the ECB will cut rates at the September 12th meeting. Mr. Draghi’s term ends on October 31st and it seems even if we see him replaced by German hawk, interest rates are set to turn lower.

Oil
Crude prices were supported earlier as Iran eased off its hard stance on when OPEC should hold their next meetings on production cuts. Tehran initially wanted to keep the June 25th meeting date but has now offered July 10-12th. After the NY close, the OPEC secretariat proposed a new meeting date of July 1st and 2nd. The decision needs to be unanimous by OPEC and expectations are high for the rest of the cartel to agree.

Global demand for crude got a boost on expectations that trade talks are showing some positive signs following President Trump’s tweets.

Oil did not see much of reaction to the API inventory report which showed a draw of 0.8 million barrels. Current expectations are for the EIA weekly oil inventory report to deliver a 1.5 million draw.  Last week’s data saw Cushing account for most of the 2.2 million build that stemmed from flooding in the Midwest.  With most of the affected refineries and pipelines returning to normal, markets are strongly expecting a draw with tomorrow’s reading.

Gold
Gold prices remain supported on expectations additional easing will be delivered across all the major central banks. Gold prices would have delivered stronger gains if it were not for President Trump’s optimistic tweet on the trade front. Trump tweeted that he spoke with Xi and that the US and China will hold an extended meeting next week at the G-20 in Japan. While today’s positive trade tone was heavily embraced, meaningful progress at the G-20 remains an unlikely scenario. The base case remains that we will not see an escalation in tariffs and that we could see a plan that outlines a potential removal of some tariffs based off of specific benchmarks.

Now well-off last week’s high of $1,362.20, the yellow metal will look to regain its bullish momentum on a very clear and strong dovish signal from the Fed.

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