Fed to hold policy at September FOMC

The Federal Reserve is unlikely to materially change policy at its September FOMC meeting but we would expect language around pulling back on more of the extraordinary pandemic-related stimulus measures to be more assured. Specifically, the Fed may lay out a time-line for when it will begin to taper asset purchases and at what pace.

Recent data points may have given pause to some FOMC members that had been openly advocating for tighter monetary policy. The August CPI print came in line with market expectations—at 5.3% y/y, down from 5.4% in July—while jobs growth for the same month sharply disappointed. On top of the slowing data domestically, the volatility in financial markets related to the potential default of Evergrande, a large Chinese property developer, could also derail a linear approach to pulling back on stimulus measures.

While data is showing signs of some easing it is by no means bad. PMI readings for both manufacturing and the services sector remain comfortably in expansion territory and their preliminary September reads are still on the cards for historically strong prints with the manufacturing PMI expected at 60.8 and services at 55. Labour market data too is showing signs of improvement, at least on a headline level. Continuing jobless claims are near their lowest level since the pandemic truly hit the US. Jobs growth, while slower in August than perhaps markets or policymakers wanted, is on a much steeper trajectory than past labour market recoveries to recessions.

Steep, if slowing, recovery in US jobs market

Source: Bloombergg, Emirates NBD Research. Note: 100 = start of recession period.

We anticipate that tapering will begin from the November FOMC meeting onward with the potential for it to be unwound completely by the end of Q3 2022 if carried out on a monthly basis. However, we still see little chance at this time of the Fed being prepared to raise rates, not least as the US economy is expected to slow further in 2022 as growth rates normalize and extraordinary fiscal support is unwound (the Biden’s administration’s plans for major infrastructure and social spending will have more of a long-term impact on the US economy, rather than necessarily being felt next year). Our baseline assumption is for the Fed to raise rates in 2023 although there may be a signal of rate hikes being brought forward when the Fed releases its updated economic projections and dot plot this week.

We expect that markets will begin to price in further normalization of US monetary policy throughout 2022 and that UST yields will move higher throughout the year. Our end-of-2022 target for 2yr UST yields is at 0.35% while for the 10yr UST yield we expect it can move to as much as 2.5%. However, that will be contingent on a steady if slowing upward move in economic activity in the US as well as inflation differentials favouring the US versus the Eurozone for instance. Downside risks to the US outlook remain evident, not least of which is a renewed outbreak of Covid-19 in parts of the US with lower vaccination rates than the national average or spillover effects should China’s economy grow much more slowly than expected.

Emirates NBD Research government bond yield assumptions