The key question remains “what” will the Fed decide tomorrow and “how” will it communicate.
The “what” means the target for the Fed funds rate which currently stands at 0% to 0.25% and could be lifted to 0.25% to 0.5%.
The “how” has increasingly become more important. If the Fed leaves its growth and inflation forecast unchanged, and Fed members stick to their median long-term forecast for the Fed funds rate at 3.75%, the market would position for a long series of rate hikes, and yields would rise in particular at the short end of the curve.
In our view, this scenario is less likely and we are in the more dovish camp that expects an eventual rate hike to be accompanied by a downward revision of the growth outlook and lower “dots”. In this camp, the long end of the curve would move slightly higher in anticipation of higher inflation in the longer term.
The market is torn between these two camps, with the yield curve moving higher both at the front and at the back end. Yesterday’s economic data was supportive for both camps, with higher retail sales being offset by disappointing industrial production data. Today’s consumer price data is likely to be non-decisive also. We all know that the headline inflation rate is depressed by the lower oil price while core inflation is moving higher due to rising rents.
Volatility will remain high but we are adding back some exposure to the USD high-yield market in anticipation of a consolidation of the oil price that will be supportive for the important energy segment, the higher spread level that compensates for the liquidity and default risk, and last but not least in anticipation of “lower-for-longer” yields that make the USD high-yield segment a valuable source of income.
Markus Allenspach is head Fixed Income Research at Julius Baer