Federal Reserve: Scenarios into FOMC – DBS

DBS Group Research economist Eugene Leow notes that investors remain cautious on upcoming FOMC decisions, with markets pricing a 34% chance of a July hike and nearly full odds for September. He highlights Taylor Rule signals for tightening, persistent inflation concerns and Oil risk premia, and outlines contrasting yield-curve reactions under Fed hold versus hike scenarios for US Treasuries.

FOMC risks for US yield curve

"Investors remain highly cautious about the upcoming FOMC meeting. The pause in US-Iran hostilities did prompt a correction lower in crude oil prices but the market is still assigning 34% odds that the Fed would hike this week and close to 100% odds for the meeting in September."

"First, our version of the Taylor Rule model points to Fed tightening. In the era of reduced forward guidance, data probably takes on greater significance."

"Second, the market is still concerned about inflation (there was a bit of a pop in 2Y breakeven over the past few trading days), the recent decline in crude prices and mild June CPI figures notwithstanding."

"The narrative around the Middle East conflicts shifts quickly and it may just make sense to assume that there will be a bit of a premium on oil prices and thus inflation for the foreseeable future."

"In the event of a Fed hold, we suspect that the curve may steepen modestly, with upward pressure more apparent in the long-end (10Y yields may grind towards the 4.7-4.8% range. Frontend yields are not likely to give up on Fed tightening that easily. If the Fed surprises with a hike, we suspect that long-end USTs may rally (10Y UST may drift towards 4.5%) on confidence that inflation will come under control amidst a more vigilant Fed."