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FOMC Preview: Fed to focus on taming the yield curve

With short-term interest rates already near-zero, the Federal Reserve will shift its focus to pinning down longer-term interest rates in its policy-setting meeting this week.

Over the last week, the yield on the 10-year Treasury (^TNX) rose to as high as 90 basis points as investors extended their risk-taking in the stock market. Despite news on Monday afternoon that the United States economy had officially entered a recession as a result of the COVID-19 crisis, optimism over re-openings sent the S&P 500 positive for the year.

That poses problems for the Fed, which would like to keep longer-term interest rates lower to keep borrowing costs cheap as the U.S. continues to work its way through recovery. In addition to near-zero short-term rates, the Fed has re-launched its crisis-era policy of purchasing Treasuries and mortgage-backed securities. It has also opened up nine liquidity facilities to address markets ranging from U.S. dollars to risky corporate debt.

Evercore ISI’s Ernie Tedeschi and Krishna Guha wrote Monday that Fed Chairman Jerome Powell faces “higher stakes” in his press conference tomorrow afternoon, even though they do not expect any major policy announcements.

“With yields surging last week on better sequential data there is a real risk of a June 2013-type taper tantrum with rates and longer term yields accelerating higher if the Fed is not resolutely dovish,” Tedeschi and Guha wrote.

The Fed has a few policy options to depress longer-term rates, namely forward guidance (by stating its intention to keep rates near-zero until inflation or employment reaches certain targets) or yield curve control (where the Fed purchases Treasuries until bond yields are below a stated level).

Federal Reserve Chair Jerome Powell speaks during a news conference, Tuesday, March 3, 2020, to discuss an announcement from the Federal Open Market Committee, in Washington. In a surprise move, the Federal Reserve cut its benchmark interest rate by a sizable half-percentage point in an effort to support the economy in the face of the spreading coronavirus. Chairman Jerome Powell noted that the coronavirus "poses evolving risks to economic activity." (AP Photo/Jacquelyn Martin)
Federal Reserve Chair Jerome Powell speaks during a news conference, Tuesday, March 3, 2020, to discuss an announcement from the Federal Open Market Committee, in Washington. (AP Photo/Jacquelyn Martin)

But most Wall Street firms say it is too early for the Fed to announce either type of policy in this week’s meeting. Bank of America’s global research team wrote June 2 that they expect the Fed to wait until September to announce a “one-two punch” of forward guidance and yield curve control targeting medium-term rates.

“We think the Fed will implement this strong forward guidance and YCC once the bounce from reopening passes and it becomes clear that the recovery will be protracted and challenging,” Bank of America wrote.

The positive surprise from Friday’s jobs report, which showed unemployment declining from 14.7% in April to 13.3% in May, may also give the Fed some more time to wait on announcing such tools.

UBS’s economics team, however, warned that there is the possibility the Fed surprises by announcing both measures tomorrow as a result of pressure from the selloff in yields.

Reading the dots

After forgoing its quarterly economic projections in March, the Fed is scheduled to release a new set of “dot plots” tomorrow that will map out policymakers’ estimates for where interest rates may be headed in coming years.

Those projections may be difficult for Powell to explain in the press conference, since economic forecasts are tied to forecasts on the spread of the virus itself.

“We are now experiencing a whole new level of uncertainty, as questions only the virus can answer complicate the outlook,” Powell said in late May.

Goldman Sachs expects the projections to show no rate hikes through the release’s forecast horizon of 2022, underscoring the Fed’s intention to keep rates low through the recovery. JPMorgan’s Michael Feroli agreed, but noted there could be some FOMC participants penciling in the possibility of a hike in 2021.

“There will probably be a handful of optimistic folks who have a few hikes in that year, and maybe even in 2021, but we think the median respondent will be more cautious,” Feroli wrote June 5.

The economic projections will also include forecasts for inflation, GDP, and unemployment.

The FOMC statement will be released at 2pm ET on Wednesday followed by Powell’s press conference at 2:30pm ET.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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