With the FOMC meeting today and tomorrow the market is pricing in very little chance of an interest rate hike at the announcement tomorrow at 7pm London time. With the UK EU Referendum just around the corner, the market is once again pushing out the outlook for further tightening. In fact traders now see less than a 50% chance of a hike coming this year.
Two questions come to mind, the first is what does that imply for the $2.5tn in US Treasuries held on the Fed's balance sheet. It was a big concern for the market back in December when the Fed moved off of near zero rates that a tightening would be followed by the start of liquidations of their massive pool of government debt bought through QE over the previous years. However, the slow pace of tightening and comments from officials that normalisation of rates would have to be “well under way” before any change in the current policy of reinvestment would be considered has pacified the market. Broadly, the Fed will reinvest around $216bn back into the market from maturities this year, $194bn next year and $389bn in 2018, as long as this current policy is retained that long. Data compiled by Bloomberg through overnight swaps data suggests that the current effective funds rate of 0.37% won’t reach 1% for at least another three years, so it would appear that the Fed’s reinvestment policy is here for a while. “It’s safe to say that not only is the ending of reinvestment further off the radar, it’s not even on the radar” was one market participant’s summation.
The second point that the market is questioning is “how low can unemployment go” with the unemployment rate hitting 4.7% in May’s release, which is the Fed’s end of year target, and so half a year early, many expect the Fed to revise its medium estimate for unemployment lower in the FOMC’s summary of economic projections which will be released tomorrow evening. The drop appears to have resulted from a further fall in the participation rate as Americans gave up working or looking for work. Therefore if the Fed leaves its unemployment call for year-end at 4.7% it assumes the central bank believe that this indicator will snap back over the coming period as dropouts re-enter the job hunt; thus slowing the declines in the unemployment rate. Given that wages are rising and the ratio of jobs to unemployment appears reasonably high, some argue that the skills gap is keeping people out of work not economic weakness. Broadly, the level seen in May was previously indicated as full employment by the Fed and so with employment being one of the key determinants of interest rate policy a move in the Fed’s projections for this indicator will be carefully studied.