December FOMC Preview

This week's FOMC meeting, which is likely the last major US economic event of the year, holds my interest. As we approach its conclusion on Wednesday, it seems almost certain that there will be no rate moves. I am particularly curious to see how successfully the Fed will push back against market pricing for the first rate cut of 2024 and total cuts over the year.

Currently, the market is evenly split for an initial reduction in the federal-funds rate next March, with near certainty that a cut will occur by May. However, I am more sceptical and foresee the Fed maintaining its target range at 5.25%-5.50% until July. Fed speakers have consistently emphasized that it is premature to discuss or contemplate rate cuts, as progress has been made on inflation and balancing the economy's supply and demand. Despite some recent softening in price pressures and economic activity, I believe it reflects an expected cooling in the economy but is not sufficient to prompt the Fed to cut rates anytime soon.

While rate-cut expectations were reduced last Friday following stronger-than-expected nonfarm payrolls, the market remains more dovish in its rate outlook than I think is correct.

This leaves the Fed with one last chance before year-end to challenge those rate-cut expectations on Wednesday/Thursday. The December Summary of Economic Projections ("the dots") will be a crucial vehicle for the Fed to send a strong signal to the market. The last set of dots in September predicted an additional hike in 2023 (which hasn't materialized) to a median level of 5.6% and a year-end 2024 level of 5.1%. The federal-funds futures-implied interest rate for Dec24 is 4.2%, nearly a full hundred basis points below the September dots prediction.

While I anticipate the December dots to be significantly higher than current market pricing, questions remain about how much lower the end-2024 dot will be and the extent of dispersion among officials' submissions. A dot plot suggesting three or fewer rate cuts next year is likely, but I wonder if this signal alone would be enough to move the market more hawkish.

Then there is Chair Powell's post-meeting press conference. Historically, when questioned about the disparity between the market and the Fed's views, he has been nonchalant, arguing that the market operates on a different model and assumptions than the Fed, and it's not his job to address market pricing. If this dismissive attitude persists on Wednesday/Thursday, it may do little to move market pricing, even with relatively hawkish 2024 dots, setting up an intellectual battle between the Fed and the market in 2024.

This focus on data, coupled with the Fed's declared data-dependent approach, suggests that each major economic release early next year will become a referendum on the federal-funds rate path. This has been evident for several weeks already, resulting in significant swings in market pricing for both the Fed and rates across the curve, leading to increased volatility in asset prices.

The anticipated data-induced volatility would occur in a bond market already affected by increased coupon supply, large intra-day price swings, and challenging liquidity. The MOVE index of fixed income volatility and an off-the-shelf index of US Treasury liquidity illustrate the persistently elevated volatility and challenging liquidity conditions since mid-2021.

In summary, I expect a relatively hawkish December FOMC meeting, contrasting with the dovish market outlook and the likely conclusion of the rate-hike cycle. The question is whether the markets will take direction from the dots or the press conference. If not, we may enter 2024 with the Fed and investors having differing views on the policy rate path, leading to a volatile set of market reactions early in the year.

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