It has taken the Fed five years and history's biggest financial crisis to convince the market that rates aren't going up any time soon. Indeed, despite the most recent UST sell-off, the market is still pricing the first Fed hike around mid-2015, with June 2016 Fed funds below 2%. As summer draws to a close, I would argue that September is lining up to be the month where Fed "forward guidance" is finally convincingly challenged. Here are three reasons:
1. Everyone is leaving. It's not just the upcoming Bernanke departure and an exceptionally noisy (Summers?) confirmation process that will drag into November. By the end of the year, more than half of FOMC voting members will have been replaced. Bernanke, Duke, Raskin, and four regional governors will have left, with who will replace the former still unclear and a far more hawkish group* stepping into the shoes of the latter. Whether the market will be able to maintain confidence on the credibility of forward guidance commitments given this change is an open question.
2. Debating thresholds will undermine their value. The July minutes indicated a potential FOMC willingness to offset a potential taper decision by lowering the 6.5% unemployment rate threshold or introducing a new inflation trigger to the downside. The intention may well be to introduce a fresh dovish bias to coincide with the end of QE. The risk is that the credibility of the threshold itself is undermined, complicating the market's perception of the policy response and encouraging a decoupling from guidance. It has already happened to the BoE and ECB, the risk is it happens to the Fed.
3. Release of 2016 forecasts. Most importantly, the Fed will release a new set of updated CPI, unemployment and Fed fund forecasts that extend into 2016. Assuming the same pace of unemployment decline embedded in current forecasts, this will likely show an economy at full employment with CPI on target by end-16. The prediction on Fed funds is more uncertain, but here-in lies the contradiction: the Fed will be fighting its own forecasts by indicating a bullish outlook for the economy but a very slow pace of tightening. Indeed, the risk is that the "dots" on the 2016 rate forecasts become even more diverse than those of 2015 (see latest one below), introducing a fresh element of uncertainty around the Fed's reaction function, FOMC member change aside.
In sum, tapering is not the most important Fed decision this September. Instead, it is how the Fed is able to simultaneously navigate big personnel change, fight its own forecasts, and signal tapering in the context of potentially undermining the value of its thresholds. Given the current data trend , the risks seem to be skewed toward the market losing faith on Fed guidance sooner rather than later. The net result should be higher US rates, probably led by curve flattening as the market brings forward Fed tightening. In turn, this should allow G10 FX to participate more fully in the latest dollar rally (NYSEARCA:UUP) that has so far been confined to EM.
*Evans, Rosengren, Bullard and George are being replaced by Pianalto, Plosser, Fisher and Kocherlakota
**Favourite dollar longs to start autumn are EUR, CAD, CHF and JPY
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long USD via medium term basket options