- Traders are the most uncertain about what the Fed will do in at least a decade.
- Expect higher-than-usual volatility around the Fed decision, with the potential for Powell to moderate whatever the decision is in his press conference.
- USD/JPY may see the cleanest, most logical reaction to the Fed meeting.
Traders and economists expect the Fed to reduce interest rates later today, but they are split over the size of the rate cut.
As of writing midday Tuesday, Fed Funds futures traders are pricing in 65% odds of a 50bps interest rate cut and a 35% probability of a 25bps reduction per CME FedWatch:
Source: CME FedWatch
FOMC Meeting Forecast
From one perspective, you could already argue that this week’s meeting has been a failure on the part of the Federal Reserve. After all, in the post-Bernanke “Fed Communication as a Policy Tool” era, this is the most uncertain that traders have ever been heading into a Fed meeting:
Source: Bank of America, Bloomberg
As the chart above shows, traders were pricing in coin flip odds between a 25bps and 50bps rate cut at the start of the week; this is the most uncertain traders have been at the start of a Fed week in at least a decade.
The lack of a clear “leak” or “sources say” story from a reputable financial reporter this week only emphasizes the level of uncertainty. While former FRBNY President William Dudley came out in favor of a 50bps rate cut, as did the former WSJ “Fed Whisperer” (Jon Hilsenrath), the current WSJ Fed Whisperer, Nick Timiraos, seems as flummoxed as the rest of the market, tweeting this morning that “The Fed faces a finely balanced set of considerations over whether to cut by 25 or 50 basis points at its meeting that begins today” and enumerating the pros and cons of each path.
Ultimately, there are two conclusions that are likely to hold regardless of what the Fed does:
- There is likely to be abnormal volatility on the initial decision. With traders unusually uncertain about the immediate interest rate decision, about half the market will be “wrong” when it hits the wires, potentially leading to a large market move as they adjust their positions.
- Powell will inevitably downplay the immediate impact of this month’s rate decision, emphasizing that the long-term path of interest rates (down) is more significant than a quarter-percent adjustment in any given month. For this reason, I expect either a “Dovish 25bps Cut,” where the Fed sets the stage for more aggressive interest rate cuts to offset fears that the central bank is “behind the curve” OR a “Hawkish 50bps Cut” emphasizing that the larger reduction is an initial adjustment and not necessarily a sign of fears about the economy.
My proverbial squirt-gun-to-my-head take: I think the Fed made a mistake by not cutting interest rates in July, and the ongoing deterioration in the labor market since then means that the Fed – an inherently risk averse institution – will opt for the “safer” 50bps rate cut to manage the risk of an ongoing slowdown in job creation. Of course, like the market, I’m far from 100% (or even 75%!) certain that is what we’ll ultimately see.
Beyond the initial interest rate decision, the Fed’s Summary of Economic Projections (SEP) will be a key factor in how the market interprets the meeting as a whole. In particular, traders will be looking for a signal in the “longer-run” interest rate dots, which show where each Fed member believes is the target interest rate under normal economic conditions; in other words, this represents the ultimate “destination” of the current interest rate cutting cycle.
The median expectation for this measure was at 2.8% in June, but it may tick up slightly toward 2.9% or 3.0%, signaling a (slightly) more protracted interest rate cut cycle looking out through next year.
US Dollar Technical Analysis – USD/JPY Daily Chart
Source: TradingView, StoneX
As we’ve noted before, USD/JPY is the currency pair that tends to have the cleanest reaction to US economic data, so readers should keep a close eye on it through the FOMC interest rate decision and Chairman Powell’s ensuing press conference.
A 25bps rate cut would likely lead to a kneejerk reaction higher for the US dollar, potentially taking USD/JPY back above the key 142.00 level. Meanwhile, a 50bps rate cut could prompt the established downtrend to resume and take the pair back toward the psychologically-significant 140 level.