Rates Spark: The Unveiling Of Warsh

We expect the tone to turn more hawkish during today's Fed meeting, but Chair Kevin Warsh might also want to push a relatively more dovish agenda. Any dovish comments are likely to remain at a very high level, however. We'll also be listening for any concrete steps to shrink the Fed balance sheet, which has the potential to steepen global yield curves.

Warsh has many unanswered questions outstanding

Kevin Warsh will make his entrée at today’s Fed meeting, which means we might get a better feel about how he intends to follow up on his policy ambitions. No change in the policy rate (3.50% to 3.75% range) is expected, but the press conference could offer interesting sound bites for markets to potentially rethink the future policy stance. Whilst the statement should turn more hawkish, Warsh may want to communicate his more dovish view, though probably not explicitly. He could, for example, reiterate his conviction about AI-related productivity growth, which would justify lower policy rates further in the future. Overall, such comments are likely to stay at a high level as he’s also not a fan of forward guidance.

Markets may also be surprised by a rethink of the Fed’s balance sheet, which Warsh would be keen to reduce significantly. We’re still in the dark about how to achieve this. The Fed’s balance sheet is now some 20% of GDP. 'Fixing' this could potentially require the sale of $2tr of mortgage-backed securities and at least half of the Treasury bonds (c.$2.5tr). Any hints about an accelerated path to unwinding the Fed’s bond portfolio could have a material impact on global rates. In effect, the additional bond supply would push up the term premium, steepening the US Treasury curve. This, in turn, would spill over in the form of steeper curves in other markets.

The ECB is not pushing back against hawkish euro rates

Also, euro rates are recalibrating to a more hawkish central bank function. Despite oil dropping below $80 per barrel, markets are strongly holding on to at least one more European Central Bank rate hike. The hawkish sentiment is in line with recent ECB comments, which seem to embrace the view that more may need to be done to fight inflation.

And indeed we see that inflation swaps are coming down on the back of lower oil, but real rates have held their ground. We still struggle to see the ECB hike more than once from here because second-round effects should remain contained. At the same time, we won't push against market pricing for the time being. Markets (and the ECB) might need more inflation data before repricing the risk of second-round effects.

Wednesday’s events and market views

Following the UK's CPI data in the European morning, the focus first turns to the ECB with appearances from Piero Cipollone, Gediminas Simkus and later Olaf Sleijpen. The ECB will also publish its wage tracker, while the eurozone will release the final inflation data for May.

The highlight of the day will be the FOMC meeting, headed for the first time by Kevin Warsh. While no change in rates is expected, markets will parse the new set of forecasts as well as the new Fed Chair’s remarks about his vision for the Fed’s policy regime going forward, given his criticism of forward guidance and the Fed’s large balance sheet. US data to watch ahead of the meeting includes retail sales and pending home sales.

Primary markets will look to Germany, which taps two ultra-long bonds for €2.5bn. Italy continues the sale of its BTP Italia SI retail bonds, which so far have run up orders of €4.7bn.