Washington Insider -- Wednesday

Pressure on Fed to Act

Here’s a quick monitor of Washington farm and trade policy issues from DTN’s well-placed observer.

Trump Wants More Ethanol Actions

President Donald Trump directed EPA Administrator Andrew Wheeler and USDA Secretary Sonny Perdue to come up with a new plan relative to ethanol as they returned with Trump on Air Force One from a visit to Iowa last week, according to the Wall Street Journal (WSJ).

The report said Trump was “surprised the expansion of ethanol sales year-round had not satisfied farmers.”

The steps under consideration, according to the report, are not necessarily new – a limit on the use of small refiner exemptions (SREs) from Renewable Fuel Standard (RFS) obligations. Farmers told Trump at the Iowa stop that the year-round sales of E15 were not a big boost since the SREs continue to be granted.

Reports this week indicated a plant to temper the SREs was presented to the White House in 2018 but was not pursued.

Biodiesel Tax Credit Resurrection in House Extenders Package

An extension of the lapsed biodiesel tax credit is part of the tax extender legislation released Tuesday by House Ways & Means Committee Chairman Richard Neal, D-Mass.

The biodiesel renewable diesel tax credits and others would be retroactively put in place for 2018 and extended through 2020. It would also revive tax credits for railroad track maintenance, two-wheeled plug-in electric vehicles and energy-efficient home construction would also be extended.

As for how to pay for the extenders, Neal is proposing ending higher exemption levels for the estate tax at the end of 2022, instead of 2025 as currently scheduled.

Most believe that Senate action led by Finance Committee Chairman Chuck Grassley, R., Iowa, on this topic will be more important to monitor, especially since the estate tax “pay for” is not likely to draw support in the senior chamber.

Washington Insider: Pressure on Fed to Act

Bloomberg is reporting that traders should prepare for turbulence around this week’s Federal Reserve decision on the theory that “markets aren’t giving up on rate cuts without a fight.”

As a result, it thinks that avoiding a volatile session today could require some “fancy policy-making footwork.” There’s a widespread desire for proof the Fed is ready to act, but too much change could raise alarm. Central bankers can adjust their message in a variety of ways, but none of them is likely to produce significantly higher yields, according to investors including Loomis Sayles & Co.’s Elaine Stokes.

The market’s doves have the Fed cornered, Bloomberg argues. If it sticks to its May pledge to be “patient” as it judges future rate moves and keeps the door open to a hike next year, riskier assets like stocks will probably slide and yields will sink further as traders rush to havens.

“The market riots on that,” said Stokes, a fixed-income portfolio manager.

Instead, the Fed is expected to take another dovish turn, just as it’s done all year as weak inflation, deteriorating growth and US trade policy uncertainty sent Treasury yields tumbling. But the Fed hasn’t caught up with rate-cut expectations and probably won’t now, with positioning as aggressive as ever. Anxiety over the Group-of-20 meeting this month has mired the yield on two-year notes around 1.85%--down from almost 3% in November--and spurred bets that the Fed policy rate will drop 65 basis points by year-end.

As a result, Bloomberg states that investors are anticipating “some combination of developments to demonstrate the Fed’s readiness to cut.” These include possibly dropped references to policy patience and inflation being dragged down by transient factors; emphasis on weak inflation and growth risks from trade hostilities; an end to the balance-sheet unwind sooner than September; and a possible downward revision of the rate-projection dot plot.

The right balance of these could nudge yields a bit higher, Bloomberg says, as traders exit some rate-cut hedges. For example, Amherst Pierpont Securities LLC’s head of Treasury trading, Paul Murphy, expects weakening in the two-year note and related futures contracts. But if the Fed convinces investors it’s ready to cut rates, wagers for a move in the third quarter won’t go away.

“The market could have a little bit of a relief sell-off and little bit of a repricing, but that would be somewhat innocuous,” Murphy said.

Don’t expect much action further out the curve, either, Bloomberg says, and cites T. Rowe Price fixed-income portfolio manager Chris Brown who said if markets are comfortable with the Fed’s messaging--and even if the G-20 summit stirs optimism on the trade front--the 10-year yield probably can’t get much higher before buyers step in. The past month’s rallies have carved out a range for the 10-year between 2% and 2.40%, he said.

It would be tough for the Fed to surpass the market’s expectations, but a rate cut might. As of Monday, pricing reflected only a 16% chance of a 25-basis point reduction at this week’s meeting.

Rewarding these bets would not clear them out, however, according to Loomis’s Stokes. By over-delivering, policy makers would only raise the suspicion that they’re responding to a bigger, undisclosed threat. Futures contracts beyond this year would gain on the prospect of more easing to come, if traders reason that “this doesn’t feel like insurance, this feels like a Fed cycle,” she said.

“If there are expectations that this is the beginning of a more drawn-out easing cycle, the impact on the curve is the most important to look at,” with a more pronounced steepening the most likely outcome, said Amherst Pierpont’s Murphy.

If the Fed doesn’t bend closer to the market’s vision, T. Rowe’s Brown expects a tantrum in three stages. Higher yields are the first and the most fleeting. “If the Fed comes off as hawkish I think you’ll see a knee-jerk selloff at the front end,” Brown said. That would quickly give way to a bullish move as a meltdown in risk assets drives buying in long-dated Treasuries, in a second wave of curve flattening. The delayed reaction is for the curve to re-steepen, he said, as investors move back into short-dated Treasuries on the conviction that the Fed will have to take emergency action later.

To Murphy of Amherst Pierpont, this is the “double-jeopardy” scenario whereby stock-market volatility exacerbates the recent tightening in financial conditions due to trade policy uncertainty. “Then the market’s really going to force them to do something later in the year,” he said.

It is clear that the pressure on the Fed just now is enormous and the choices difficult, making these decisions very high stakes—and that these are policies that producers should watch closely as they emerge, Washington Insider believes..

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