Key Points:
- Markets are pricing in a 15% chance of a hike.
- Jawboning likely following the decision.
- Fed likely to hold rates steady at 0.50%
The US dollar has largely softened over the past 24 hours as the market comes to grips with a looming risk event in the form of the pending US Fed decision on interest rates. Despite some seemingly robust core inflation figure, and a variety of FOMC members who love to jawbone the market with hawkish statements, the expectation remains that the Fed will not hike rates. Although I largely agree with the overall sentiment, it is salient to take a look at a couple of different hypothetical scenarios for the coming week:
Option1: The Fed Hikes Rates by 25bps at the Coming FOMC Meeting
The latest market expectations of rate hikes are currently running at around 15% and this would suggest that the risk of a rate hike has largely not been priced into the USDX and various currency pairs. Subsequently, a surprise hike by the central bank would cause some sharp volatility and catch many traders by surprise. In addition, US equity markets would feel the pain and come crashing down as the Fed signals a new era of monetary tightening.
Option 2: The Fed Holds the Federal Funds Rate Steady at 0.50%
This outcome is the primary forecast of most analysts and economists based on the abject lack of consistent inflationary pressures within the US economy. Subsequently, despite a strong Corp CPI result last week and ongoing tightening within the labour market, the Fed has little reason to need to tighten without rampant inflation. The argument that they need to “get ahead” of inflation is folly until we see inflation flowing through into the wage market.
Subsequently, the market is largely expecting the central bank to remain on hold at the pending meeting. This is especially evident given the overall weakening of the US dollar in the past 24 hours and largely squares with market expectations and yield curve. Expect the announcement to initially cause some volatility but any sharp movements will be temporary and the greenback will return to a stable value relatively quickly.
Option 3: The Fed Holds Rates Steady at 0.50% but highlights November’s FOMC Meeting
In this scenario the central bank again bows to the broader lack of inflation and elects to keep the FFR steady at 0.50% but returns to a hawkish tone by suggesting that the economy is improving and that November will be a “live event”. This could be a relatively problematic scenario to trade given that you are likely to see both a bearish and bullish swing that will depend largely on how effective the expectation setting actually is. It would subsequently remain to be seen at just what level the USD would settle at following such an event.
The Likely Outcome and How to Trade it
The most likely scenario is that the Fed will hold the Federal Funds Rate steady and will seek to not make any moves on tightening. The reality is that a lack of inflation is impacting most of the developed world and the US Fed simply has no case to raise rates without some form of consistent price pressures. In fact, they could do the economy more harm than good by signalling that a cycle of tightening is on the way.
However, the central bank does have a rather large problem with equity markets which have boomed based on the various QE injections and cheap money. Simply put, the Fed has blown the largest bubble in the history of US equities and this is clearly going to unwind once rates start to normalise again.
Subsequently, the likely scenario is option 3 where the central bank seeks to hold the FFR steady whilst jawboning the market that near term rate hikes are likely upon us. This tactic is likely to buy the Fed some time to slowly let the pressure out of equity markets without causing the sort of damage that can alter elections.
Now as for how you should potentially trade the event, my suggestion is to avoid the risk decision all together. The Federal Reserve is notoriously difficult to predict, even for season market strategists, and this meeting is tougher than most when you consider that there are currently competing agenda’s. Subsequently, I would counsel you to take the opportunity to step back from the markets over the next 24 hours and then re-enter once some sort of stability has been reached. Sure, you might “miss out” on some moves, but at least your capital will remain in-tact for the long term.