FOMC Preview: A Softer Tone‏

We expect a softer tone at this week's FOMC meeting but no change in policy.

A scale up in monthly asset purchases is not off the table, but we do expect it to take more time with weak data. So far, FOMC members prefer to guide market expectations with communication rather than by adding to its purchases.We expect signs of improvement to have materialised ahead of the June FOMC meeting, and hence we still believe the next move will be a tapering of QE. A slightly more dovish FOMC will probably sustain, but not accelerate the downward trend in rates.

Economic data weak but not weak enough
We expect this week’s FOMC statement to acknowledge the recent weakness in economic data. In March, the tone on the labour market was upbeat, stating that ‘labour market conditions had shown signs of improvement in recent months’. Since then we have received the March employment report, which showed a disappointing 88,000 employment growth, a weak retail sales report and the ISM manufacturing index dropping almost three points. This all suggests fiscal tightening is beginning to bite on U.S. growth.

We expect April job growth to come in at the wrong side of 150,000 as well. The employment report is due for release only two days after the FOMC meeting, and we expect FOMC members to receive a heads up from the Bureau of Labor Statistics.

This leaves the question of whether data has been weak enough to trigger an increase in monthly asset purchases. Given comments from leading FOMC members such as Bernanke, Yellen and Dudley, we do not expect such a move yet. All three have talked about adjusting asset purchases, but it has been all about when to start scaling down. Although the possibility of scaling up monthly purchases is not off the table, we believe it would take a couple more months of considerable weakness in job growth to trigger this. It seems that the FOMC prefers to use communication to adjust its policy by pushing market expectations for the QE exit date into the future.

Another reason not to expect a major change this week, is that decisions to alter the monthly size of QE are likely to be taken at meetings associated with updated economic forecasts and a press conference. Such a meeting is not scheduled until June 18-19, and we expect the data will show signs of improvement again.

Since the peak in March, US bond 10Y yields have declined 40bp on the back of weaker economic data, as other global central banks have moved towards further easing. With most of the yield curve touching its lowest level so far this year, and little prospect of a sudden reversal of monetary easing, we believe positioning has turned from moderate short to slightly long. From this perspective, a slightly more dovish FOMC would probably not be able to accelerate the downward trend in rates. Until macroeconomic data begins to improve, rates will probably continue to grind lower and a softer FOMC would support this.

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