September is likely to be dominated by a number of key event risks, in addition to ongoing uncertainty around the US growth outlook, the Fed’s reaction function and heightened EM volatility.
Fasten Your Seatbelts
1. Potential US strike on Syria
US officials are reportedly preparing to launch missile strikes at strategic targets inside Syria in reaction to the Syrian government’s alleged use of chemical weapons last week. The British parliament held a vote on whether to authorize the use of military force in Syria, but the vote failed, leaving the US with less support from key allies than expected. However, according to press reports there is a reasonable probability of a unilateral US strike over the weekend or early next week. Nevertheless, markets seem largely unfazed heading in to the long US weekend, though the situation remains highly uncertain.
Rates implications: oil shock and rates
It is too early to assess the economic and rates implications of a potential strike given the uncertainty around the timing and duration of the conflict and possible spill-over in the region. However, there has already been a sizable run-up in oil prices this week (Brent crude is up 4.8% since last Thursday’s close) and this could have effects on rates. Table 2 shows the average impact on 10y nominal Treasury yields, real yields, TIPS breakevens and the stock market in episodes where oil moved by more than 1 standard deviation over a month.
The most obvious impact is a consistent rise in TIPS breakevens across episodes. The impact on nominal rates is mixed, with half the events leading to a rise in nominal rates and half declining. Table 2 isolates market shocks in certain specific oil shock periods. Clearly, the effect on nominal yields is ambiguous, but real yields have generally declined and breakevens have consistently risen.
2. FOMC meeting
Markets have been fixated on the timing of tapering, but there will be a number of other important aspects of the September 18 FOMC meeting.
Apart from the decision to taper or not, also crucial to the market will be guidance around the size and composition of tapering and guidance around the forward tapering path. The FOMC statement may or may not introduce language addressing this issue, but Fed Chairman Ben Bernanke’s press conference will likely cover it.
Any changes or clarification around the forward guidance thresholds will be important for the front end. However, the minutes of the most recent meeting suggest the FOMC is not close to agreeing on whether to modify the forward guidance thresholds.
The Summary of Economic Projections (SEP) at 2:00pm ET will for the first time reveal 2016 forecast ranges and central tendencies for the 19 participants. Apart from the projections for growth, unemployment and inflation, the key will be participants’ forecasts for the fed funds target rate at the end of 2016 (Chart 2). This will be the market’s first look at the Fed’s expectations for the pace of the hiking cycle. Until now, the focus has been on when hikes might begin, with little guidance regarding the path of policy after the first hike.
Rates implications: biggest surprise may be the 2016 forecasts
We estimate the market has almost completely priced in a September-tapering decision by the Fed. The lone taper trade that we find attractive for now is to be long spreads in the 10y part of the curve. We believe the market may be pricing in a stronger Treasury taper relative to MBS, which in our view is unlikely. Even if the Fed tapers MBS purchases by just $5bn and Treasuries by $10bn, spreads could widen as the Fed clarifies that it is willing to taper in MBS despite higher mortgage rates.
The market is priced for the first Fed hike in early 2015. If the Fed were to lower its unemployment threshold to 6%, for example, these expectations would likely be pushed out by up to six months, supporting a rally in the 2-3y sector.
We believe the 2016 target fed funds scatterplot in the SEP will be key for the 3y-5y part of the curve, which is pricing in a very slow pace of rate hikes by historical standards. Note that the core of the FOMC expects the fed funds rate to be around 1% by the end of 2015 (Chart 2). If, for example, these members were to show a 3% target for the end of 2016, assuming they forecast the economy to be at full employment and inflation to beclose to 2%, the reds-greens part of the Eurodollar curve could continue its recent steepening trend (Chart 3).
3. New Fed chair and FOMC composition
Over the last few weeks the market has also been grappling with the impending announcement of President Obama’s nominee for Fed chairman. The President could provide further clarity on this in late September/early October. The two front runners, as reported by most of the press, are current Fed Vice Chairman Janet Yellen and former Treasury Secretary Larry Summers. However, recent media reports suggest Obama is likely to nominate Summers.
Apart from uncertainty about the chairman, there is also substantial uncertainty around the rest of the FOMC next year. Doves Evans and Rosengren will be replaced by hawks Fisher and Plosser while centrist Cleveland Fed President Pianalto, a voter in 2014, is retiring. Also, 3-5 new board members are likely to be appointed given the departure of Duke, Raskin, Bernanke and the expiration of Powell’s term, plus an additional seat if Yellen were to leave. In our view, it is possible that the President could nominate more dovish members to fill these open seats as a way of “balancing out” Summers.
Rates implications: chairman appointment will be key
We would expect the rates market to sell off on a Summers appointment but rally if Yellen is appointed. In recent comments, Summers has highlighted upside risks to US growth, the inefficacy of QE and the potential for the output gap to narrow quicker than expected. While his eventual actions may not be as hawkish as market expectations, rates are likely to price in an increased probability of an earlier end to QE and an earlier Fed hike. Further, the “optimal control” policy model, which prescribes a later start to the hiking cycle as Vice Chairman Yellen highlighted last year, may no longer be applicable under a different chairman.
4. Fiscal deadlines
Headlines from Washington have dimished with Congress on a month-long recess, but the fiscal battles should heat up again in late September. There are two key deadlines looming when Congress returns from recess on September 9. The continuing resolution that currently funds much of the government (given that neither a budget nor appropriations bills have been passed) expires on September 30. A new resolution or appropriations bills must be passed to keep part of the government funded with annual operating discretionary funds in the new fiscal year.
Second, Treasury Secretary Jack Lew highlighted this week that on October 15 the Treasury will exhaust its extraordinary measures, which have kept the Treasury operating at the debt ceiling since May 18. At that point the Treasury will be left with an estimated cash balance of $50bn, which will likely last until the end of October (Chart 4).
Rates implications: likely muted
The likeliest scenario, in our view, is another continuing resolution that extends discretionary spending at levels consistent with the sequester and an extension of the debt limit for another year, until after the 2014 midterm elections. A market reaction similar to 2011 is unlikely and rating agency uncertainty is also lower this time. Refer to That ceiling feeling for a detailed comparison of market reaction in 2011 and likely implications this time.
5. European risks may resurface
Our European economists highlight there are plenty of risks around the periphery in the aftermath of the German election, since politicians have tried to push the most contentious issues into the background in the hope that they will be overshadowed by growth (Chart 5). The Eurogroup meeting in mid September, German parliamentary elections (September 22) and the Greek October review (discussions likely to start in September) are likely to be the key headline risks.
Apart from this, local elections in Portugal at the end of September and developments around Berlusconi and the stability of the Italian Government are also likely to generate some headlines.
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