Fed time, yields surge

The Nasdaq is lower ahead of the FOMC policy decision that will likely deliver a much more upbeat outlook that should allow the Treasury yields to continue to climb higher.  The Fed will remain dovish and the dot-plots will show stubbornness against a rate hike in 2023.  The cyclical rotation trade is how traders want to be positioned ahead of the FOMC decision.

Fed Countdown

Ready or not here come higher rates.  The improved outlook warrants rate hike talk but that won’t likely force the Fed to move up their calls for a rate increase.  Fed Chair Powell will be optimistic but patient and flexible in waiting to see how the recovery unfolds.  It will be hard to justify the current level of accommodation much longer, but they should be able to get away with it for a couple more meetings.

Bond traders are already expecting the 10-year Treasury yield to finish the year around 2.0%, so not many would be surprised if we overshoot and hit 2.25% at some point this year.  The Fed is not in a rush to signal what are the inflation thresholds that would get them worried over the long-term, so traders should expect Powell to deliver another dovish dance.

Powell wants to avoid a communication mistake, like the moment Fed chief Ben Bernanke had in May 2013 when he triggered what is commonly called the “taper tantrum” when he tipped their intentions.  Bernanke’s moment triggered a bond market collapse that in a couple of months sent the 10-year Treasury yield from 1.60% area to just under 2.50% in a couple of months.  Powell will do his best to remain dovish and can still focus on the short-term virus variant risks to the outlook and uncertainty to how strong this economic recovery will be and last.

SLR

The Fed could also hint towards an extension of a special exemption for bank leverage.  Large US banks have seen their deposits skyrocket after the Fed bought more Treasuries due to all the stimulus getting pumped into the market.  These bank giants with over USD250 billion in assets must keep capital equal to at least 3% (the biggest need 5%) of their assets, including loans, investments, and real estate.  It shouldn’t surprise anyone that they want the Fed to extend the emergency that gives banks some leeway with the supplemental leverage ratio (SLR).  If the SLR is not extended, it could force banks to raise their capital requirements and that could impact the short-end of the curve.  The Fed will have to decide by the end of the month when the SLR exemption expires.   Some lawmakers want this rule to end as banks are now in a strong position and have been able to resume dividends and share buybacks.

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