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Fed preview; could dovish sentiment spur a rally?

With markets focused upon falling oil prices, this week’s FOMC meeting has somewhat crept up on us. With a dovish shift from the committee likely, could we see a rally in GBP/USD and US 500 – both before and possibly after the event?

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Federal Reserve building
Source: Bloomberg

This week sees the first Federal Reserve meeting since the decision to raise the Federal Funds rate by 25 basis points last month. Initially seen as the first step in setting the FOMC on a pathway towards interest rate normalisation, many are speculating this was too soon given the continued deterioration in oil prices and subsequent crash in equity markets. Given those concerns and the proximity to their first hike (the FOMC promised gradual rate rises) we believe the likeliness of the Fed raising rates is negligible.

However, Fed Funds futures are factoring in a 12% chance the Fed will raise rates once more on Wednesday, which should introduce enough uncertainty to hopefully introduce volatility in either case. No doubt, a rate hike would do far more damage than a decision to maintain rates would benefit equities worldwide given those percentages.

Despite that perceived 12% chance of a hike, the reality is likely to be significantly less than this. With that in mind, this meeting is expected to be all about the phraseology and any perceived change in sentiment rather than any tangible change in policy from the Fed.

The Fed’s ‘dot plot’ is one good source of information regarding expectations for future interest rate hikes. Encompassing the views of all Fed members in relation to where they see rates at the end of the current and next three years, it provides a great clue as to shifting sentiment within the group. The completion of the 2015 year means this month will provide us with another column, covering the 2019 period. However, the important thing for markets right now is in relation to how many hikes we will see in 2016.

Given the expectations of a 25 basis point move each time, the December dots point towards four hikes in 2016 given the cluster at 1.25-1.5%. With that in mind, the dramatic collapse of equity valuations and crude prices since that meeting is surely going to raise the likeliness of a lowering of near-term expectations, with dots shifting down the chart. Clearly, alongside the speech by Janet Yellen, this dot plot could be one key source of potential dovish sentiment for the markets on Wednesday.

Another key aspect to consider is the degree to which markets have factored in any change in stance on Wednesday. Unlike the December European Central Bank (ECB) and FOMC meetings, this month has seen precious little focus upon Wednesday’s meeting as traders contend with falling oil prices and the impact that has had upon both currency and equity markets. Given the likeliness of a more dovish shift on Wednesday, we would expect to see dollar weakness and stock market strength in the lead up to this event.

The US 500 did see a strong end to last week, largely due to Thursday’s dovish ECB meeting which saw Draghi allude to further easing at their March meet. However, what that did do was provide a strong base which set up a more bullish mentality coming into this week.

The beginning of this week has started somewhat slowly, with some of those gains being eroded. Nevertheless, this move lower looks more like a retracement, with another move higher likely to be around the corner. With that in mind, it is worthwhile watching the US 500 for signals of another move higher.

In particular a closed hourly candle back above 1880 which would provide a powerful bullish signal with 1909, 1915, 1934 and 1954 representing the next key resistance levels.

A similar story has come to play for GBP/USD given the rally we saw following Thursday’s ECB meeting. That rally saw price break through the $1.4340 resistance level which creates a new high and highlights the potential for a resurgence in the pair.

With the possibility of dollar weakness in the offing, the current retracement for this pair looks like a bullish retracement before another leg higher. Noting the fact that many of the recent four-hour candle have exhibited long lower wicks relative to the complete body, it is clear that the selloff does not carry a great amount of momentum. As such, an hourly close back above $1.4264 would provide a bullish signal in the lead up to the event. Should this occur, it would point towards $1.4363, $1.4476 and $1.4566 as the next major resistance levels.

How any central bank event plays out will always be difficult to pin down, yet with markets seemingly sleepwalking into this event, we are seeing a position where perhaps the likeliness of a more dovish Fed has not been fully factored in. With that in mind, dollar weakness and strength for the major US indices seems a likely occurrence in the lead up to this Fed meeting. The one word of warning is that given the huge impact crude oil prices are having upon indices in particular, there is always a chance we could see another leg lower for oil, which would likely override any bullish sentiment building ahead of Wednesday’s meeting.

This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.  Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. 

CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.