The Fed could disappoint markets Wednesday, even if it keeps a super dovish tone

The Fed may see a brighter long-term outlook when it releases its economic forecasts Wednesday due to vaccine developments, but it also has the opportunity to disappoint at least some investors who are expecting immediate changes in its bond buying program.

The market has been divided about whether the Fed would extend the duration of its $80 billion Treasury purchases, meaning increase the purchases at the long end, like the 10-year note and 30-year bond. Theoretically, that should help keep down the longer term rates that impact mortgages and other loans.

But a number of economists instead expect the Fed to simply give out more information and guidelines on what would prompt it to make changes, saving the actual policy shift for later. Rates for now, are still low and financial conditions are favorable, and it is still unclear how much stimulus Congress will provide the economy.

The Fed will release its statement at 2 p.m., and Fed Chairman Jerome Powell holds a 2:30 p.m. ET briefing.

Because of the split views, the Fed has the potential with its Wednesday statement to move markets. The bond market has been betting to some extent on increased purchases of longer dated notes and bonds.

“Somebody’s going to be disappointed,” said Ian Lyngen, head of U.S. rates strategy at BMO. “I think it will be a tradeable event in one way or the other.” But if it doesn’t change the bond program, he doesn’t expect the bond market to see a big move, since the Fed will still hold out the prospect by saying it stands ready to act.

“At the end of the day they’re going to be dovish,” said Rick Rieder, chief investment officer of global fixed income at BlackRock. “The question is are they going to be dovish or super dovish? So do the extend the [duration of purchases]? I don’t think it matters when they do it, at this meeting or next. I think they’re going to do it.”

Rieder expects the Fed to ultimately shift the asset makeup but also increase the Treasurys purchased to $100 billion and reduce the $40 billion in mortgages it is currently also purchasing.

“I think they are very receptive to buying more assets,” said Rieder. “I think they will discuss doing it, rather than doing it,” said Rieder. “I think they are watching to see what the the fiscal is going to do…I think they’re going to determine how much fiscal requires, how much funding they need and what their response needs to be.”

Rieder said he expects a stimulus package in the first quarter, though Congress continues to try for a compromise package this week. Any package will result in a lot more debt to be issued by Treasury.

“I think we’re entering a new era of more fiscal stimulus, more borrowing, and more participation of the Fed,” he said.

The Fed’s current bond buying program is the pandemic crisis version of quantitative easing, first introduced by the Fed during the financial crisis. The Fed hurriedly reintroduced the program without the type of perimeters it previously used. That provided a powerful impact on markets, which were stressed by the abrupt shutdown in the economy last March.

Now the market expects more definition of how the Fed will use the program. Some Fed watchers say the Fed would be better served waiting to see what sort of stimulus plan Congress develops before acting, and others, like Goldman Sachs, argue the spread of the virus at a record pace should be a catalyst for the Fed to act.

“We think the Fed is slightly more likely than not to extend the weighted average maturity of its Treasury purchases, though it is a close call,” they wrote. The Goldman economists expect the Fed to get more bang for its buck if it buys longer dated Treasurys than the shorter maturities, which are impacted more by its interest rate policy.

“We expect the FOMC to adopt outcome-based forward guidance indicating that purchases will continue ‘until the labor market is on track to reach maximum employment and inflation is on track to reach 2 percent,’ a softer version of the thresholds used for liftoff of the funds rate.” the Goldman economists added.

Citigroup economists expect just a 25% chance the Fed alters the bond buying program, while Bank of America economists expect the Fed simply to change the language about its program but hold off on actions. “The focus of the upcoming meeting will be on language changes as we expect the FOMC to leave its policy rate and its asset purchases unchanged. We believe neither economic nor financial conditions are sufficiently dire to warrant additional policy easing at this time,” notes Bank of America.

Diane Swonk, chief economist at Grant Thornton, said she thinks the Fed should keep its powder dry, not make changes but provide guidelines for what would make it move.

“I think they should wait it out until they see if they have to pull the trigger. They are long-term bond holders. Once they go, it’s going to be harder to unwind it. You have to have a good reason to do it,” she said.

“I don’t think the Fed wanted to be in this position, but they didn’t define clearly enough what they were intending Whatever we hear from them would give them the flexibility to do something by the end of the week if Congress goes home and doesn’t do anything. They don’t have to wait until January,” said Swonk.

Swonk expects the Fed will also change the way it presents its economic forecast, to provide more context around risks to the forecast. “You could have a revised higher forecast with more risks,” she said. The Fed could note that the near-term outlook is weak because of the economic impact of the rising number of coronavirus cases across the country. But it may see a better longer term outlook because of the vaccines, which are just starting to be administered.

The Treasury clipped the Fed’s wings by declining to extend some of its emergency programs and instead diverting the funds to fiscal stimulus. The municipal bond and corporate bond facilities were closed down as of year end, as is the Main Street lending program. But Fed watchers expect once the Biden administration takes over and former Fed chief Janet Yellen becomes Treasury Secretary, those programs could be resumed if the Fed thinks they are necessary.

Rieder said the Fed is in a unique position with Yellen at Treasury and they could forge an important partnership.

“I think people understand this is a big deal, in particular, in that both are going to be dovish. The economy can handle more accommodation and more fiscal, funded by the Treasury and supported by the Fed,” he said.

Source by www.cnbc.com