Federal Reserve Preview - Firmer Support for Markets Coming via More Liquidity

US macro data has recently been balanced, suggesting that the Fed has no need to change policy. However, worries over global growth have picked up again recently due to the coronavirus outbreak in China, which has led to one rate cut this year now being fully priced in. We think the Fed is likely to be somewhat dovish this time around, keeping rates on hold but providing support to the markets by extending its T-bill purchase program into 3Q20, which would be negative for the dollar and 3m LIBOR rates.> Today, at 22:00 Moscow time, the Fed will announce the outcome of the FOMC meeting, which began yesterday. Fed Chair Powell will give a press conference 30 minutes later.> Recent US data has been fairly balanced: inflation remains near the 2% target, job growth is solid, and the preliminary PMIs for January pointed to a moderate expansion in the manufacturing and service sectors. The US economy is neither too hot nor too cold, meaning that the Fed did the correct thing by cutting rates by 75 bps last year.> Against this backdrop, we expect rates to be kept on hold. However, the recent risk-off sentiment sparked by the coronavirus outbreak caused US Treasury yields to drop 15 bps at the short end and more than 30 bps at the long end.> The market is now fully pricing in one rate cut by the end of this year. We believe that the Fed understands that the US-China trade war has left the global economy vulnerable, so we expect it to be relatively dovish today, and we would not rule out further cuts if the Chinese - and by extension the global - economy slows significantly as a result of the virus, thus pressuring the US economy. However, we think calls for a cut are premature at this juncture.> But given the current environment, we think the Fed will opt for another policy easing tool that could be more appropriate and provide markets with some psychological support: it could extend its T-bill purchases from "at least into the second quarter of 2020" to 3Q20.> The Fed has been buying T-bills at a rate of $60 bln per month since last autumn in response to an acute dollar liquidity deficit following several years of winding down its balance sheet.> Since then, it has injected almost $400 bln of liquidity by buying T-bills and repo. This has been sufficient to bring O/N rates back under control, but until the very end of last year, the 3m LIBOR-OIS spread remained elevated due to fears of a seasonal dollar liquidity deficit at year-end. However, this did not materialize, and the 3m-LIBOR-OIS spread has eased by 10 bps YTD. Should the Fed extend its T-bill purchases through to 3Q20, its balance sheet could expand to $4.5 trln, which is where it was before it started reducing it, while the 3m LIBOR-OIS spread could slide by another 10 bps.> So we anticipate relatively modest policy easing in terms of 3m interest rates, which will be brought down by the added liquidity. This could be positive for riskier assets and negative for the dollar. Moreover, we think these T-bill purchases are having a positive psychological effect on the markets: some investors believe that this liquidity is flowing into the equity and debt markets. We do not entirely agree, as the Fed's expanding balance sheet is causing its liabilities to grow, i.e. banks and funds end up placing more money with the Fed or utilizing its reverse repo operations. However, the ample dollar liquidity means that investors are now generally calmer, in stark contrast to previously, when the liquidity deficit and surrounding hype amplified risk-off moves.