Tonight's FOMC meeting could be a little more interesting than we think

Wednesday, 1st May 2019 12:48 - by Shant

As markets prep up for the FOMC meeting, there is an air of optimism that the Fed will stick to their script for 2019, having not only signaled a pause in their tightening cycle, but also timetabled the end of the balance sheet runoff which was as much the cause of the sell-off in Q4 last year as was the fourth rate hike in December.  Since then, the recovery has lifted the Wall Street indices back to their highs, with the leading S&P 500 index printing new record highs in the past week. 

Alongside the Fed pivot, earnings seasons have not been as soft as analysts had predicted, while some of the recent data out of China has also reined in some of the bearish forecasts on global growth.  We need to see a series of numbers to back up the latter view and indeed this week, the more recent PMIs (in China) were a little less encouraging. But back to matters closer to home, and tonight's announcement and rhetoric from the Fed will cover a number of topics, not least of all the rise in the EFFR - the effective Fed funds rate.  

The rise in the EFFR - a volume weighted median of overnight Fed funds transactions - has caused concern among market participants in recent weeks, as it has now risen above the IOER rate - the rate paid by the Fed on excess reserves.  This signals potential funding issues on what is effectively the price of Dollar, sparking fears that there may be a fresh Dollar shortage for funding purposes - a precursor to distress in the markets which has clear indications for risk asset valuations - in short panic.  In response, the Fed is expected to address the issue - and if may well be a case of suggesting this is a temporary phenomenon, as the timing coincided with the tax deadline, payments and a concurrent drop in reserves.  However, given that Fed funds are the central bank's primary means of controlling the 'price of money', some suggest we may get an adjustment in the IOER, which may well be read as the start of a turn in the cycle which the market has already priced in at the end of the year. 

Whether this is a reason to send global stocks remains in the balance, as higher funding costs due to Dollar shortages can spell trouble as noted above.  Furthermore, if the rise in funding costs are primarily down to the level and perceived tightening of excess reserves, then the Fed may well need to communicate an end to the reinvestment caps which are currently set for the end of September.  Either way, markets are anticipating some degree of appeasement in the Fed this evening, and this is partly reflected in a modest softening of the Dollar.  Equity markets seem to be moving with this familiar correlation also, but once again, the way the Fed communicates its thoughts on the firming up of the EFFR this evening will be key for markets. Given their renewed caution in avoiding any fresh turbulence in financial markets, one can assume that any message will be delivered with a heavy dose of calm.  

To that end, perhaps sticking to the established script from the start of the year may be taken in a hawkish context - which is effectively less dovish - which could lead to some correction given we are pressing new record highs.  One thing is clear and that is Fed language carries with it a very high - or higher degree of sensitivity - and reading between the lines seems to have moved up to a new level! 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.