Market Watch, Sept. 18

The Fed meets this week, and it could start up the "greatest taper" of all time.

Uncertainty lies ahead for the US Federal Reserve

Australian data is out this week and there should be a number of things on our agenda, namely: the RBA minutes and bulletin, building permits, and new motor vehicle sales. That being said, our focus is on something far more important, possibly the biggest macro event of 2017 – the Fed's monetary policy. Thursday's meeting will mark the first change to the monetary policy at the US Federal Reserve since December last year.

The reason for concentrating on one central bank this week is the effect it could have on Australian funding mixes. Over the last 18 months Australian banks have blamed wholesale funding for increasing lending rates out of cycle. The major contributor to this rise in wholesale funding has been US interest rate rises during the same period. Global markets are now faced with a similar scenario as the Fed gears up for another round of tightening.

With this in mind, here are the keys to the Thursday morning (AEST) meeting:

The great taper: The Fed has given every indication it will begin to unwind the largest balance sheet expansion undertaken in human history on Thursday. Its $US4.6 trillion purchase of US treasuries and mortgage-backed securities during the GFC had two mechanisms for unwinding built into its mandates – holding to term or a gradual unwinding at a time the board deemed appropriate. The latter is now the case.

Expectations are for the Fed to begin selling $US10 billion a month in long date securities. The effect of selling at the back end of the curve will steepen the US yield curve, which effectively increases rates. The correlation here is that the corporate bond market will also increase, which means the banks will have to cover a higher coupon rate. I would also expect the Fed to allude to a possible increase in the monthly unwind as conditions warrant in the future.

A December rate rise: Look out for further talk about changes to the Federal funds rate. Yellen and Co. are slightly divided in this case, but the main board is of the opinion the US economy could handle a ‘gradual increase to the Federal funds rate'. Considering the mandate of the Fed is ‘full employment' and ‘mean-inflation at 2 per cent', a case can be made that the US economy could handle further changes to the Fed funds rate (however, mean inflation is still below this level). Markets have been backing away from a December rate rise, with the interbank market only pricing in a 40 per cent chance (it had been as high as 65 per cent). However, any language around December being a ‘review of policy' meeting will likely see this figure higher and the market will begin to price in the possibility of further rate hikes.

The politics: The catch for the Fed is that four out of the seven voting panel positions are vacant, and of this four at least two are to be filled by President Trump. His current stance is for highly accommodative monetary policy and for further monetary stimulus. He could bring in his candidates sooner than expected (November at the earliest), which would delay and even reverse policy change from Thursday.

The role of chair, Yellen's current position, itself is up for renewal in February. She is unlikely to be reinstated, which means in the March meeting (the first major policy meeting of 2018) the Fed could have a very different outlook to the current Fed.

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