The March FOMC playbook

The Federal Open Market Committee meeting, where we should get the policy statement and revised economic projections, takes place this Wednesday at 6pm (London time).

Traders
Source: Bloomberg

Janet Yellen also takes to the stage thirty minutes later for her quarterly press conference (including a question and answer session), which could promote increased volatility in markets.

In 2015 alone, some 24 central banks globally have eased monetary policy as falling inflation has forced a more accommodative stance. On the other side of the scale, the Federal Reserve has been quite vocal about a desire to increase interest rates and start a normalisation process. In turn, this massive divergence in policy settings is having huge ramifications on capital markets, with the dollar seemingly the epicentre of the moves.

Much ink has been spilt over whether the US economy is strong enough to withstand a lift in the funds rate, and this has opened up the key question within the Fed; should it hike earlier and be less aggressive, or act later and potentially steeper?

There could be huge implications on emerging markets as well, although the fate is that these regions will be dictated to by US bond yields. An aggressive selloff (causing US bond yields to move higher) would result in strong capital outflows from many geographies, especially from any country that runs a sizeable current account deficit and requires high levels of external funding. In this vein, China is absolutely key and how it manages its currency is going to be fascinating.

Key narrative to watch out for

The Federal Reserve has held a view that it can be ‘patient in beginning to normalise the stance of monetary policy’ since the December meeting. Importantly, this statement is predicted to be altered and the word ‘patient’ removed, with Janet Yellen fully expected to temper this with a view and stress that the path of rate increases will be data-dependent. This means that from June, every meeting is effectively ‘live’ and we could see the funds rate going up at any stage.

Commentary around the dollar is pivotal for traders, as the pace of the currency’s ascent of late has been ferocious and must be a huge concern for the Fed. It seems logical that it will talk more openly about the currency and perhaps suggest the dollar will play a greater role in its policy settings. This could take some of the heat out of the currency, which in turn could be a net positive for equities.

A failure to express a big concern around the recent dollar strength would be a green light to add to long dollar positions, although I feel playing the rates markets is a good strategy and being short Eurodollar futures (September) would be a great place to be in this regard.

Naturally commentary around slack in the labour market, wage pressures and the transitory factors affecting inflation (mainly due to the oil price) will shape interest rate expectations and subsequently market moves.

Economic projections

The Fed’s economic projections will shape market pricing around how aggressive the central bank will be with future policy settings. From the last set of economic projections (provided in December) it is really inflation that traders are most focused on. Expect core personal consumable expenditure (PCE) to be lowered to a range of 1.3%-1.6% this year, and 1.6%-2% in 2016, down from 1.5%-1.8% and 1.7%-2% respectively.

In terms of growth, it would not be a surprise to see forecasts of 2.5%-2.9% this year, which is a modest downgrade from the December projection. No changes are expected for 2016 and 2017.

We could also see some modest tweaks lower to its forecasts for the unemployment rate, with a range of 5.1%-5.3% likely for this year. Coincidentally, this is fitting with the levels the Fed sees as full employment.

The Fed’s view on rates

There will be some focus placed on the Fed’s projections on where rates should be at the end of each year, or the so-called ‘dots plot’. As things stand the current median forecast for the Fed fund rate held by the 17 members of the board is 1.125% for 2015, 2.5% in 2016, and 3.625% in 2017. Its long-run objective is 3.75%. Bear in mind this is the median projection and expectations vary widely. One board official even feels rates should be at 4% next year; imagine where US bond yields and the dollar would be if we see the funds rate there.

I would not be surprised to see the median projection for rates being revised down to 1%, or even to 0.85% (from 1.125%). However, a failure to lower the current projection from 1.125% should cause another leg up in the dollar as it implies a more aggressive tightening path than what is currently priced in.

Market pricing

Interest rate market pricing is fairly benign at present and there seems to be a dislocation between what economists and traders are expecting. Looking at the Fed fund futures contracts we can see a modest 19% chance of a June rate hike, compared with a 58% probability for September, according to CME Group FedWatch. This tells me that traders are sceptical about Fed action and are expecting the process to be very gradual. On the other hand, a recent survey from Reuters saw 15 of 16 primary dealers (the firms that deal directly with the Fed) calling for rate hikes to start in June.

There seems to be enough evidence from the US and global economy to support being conservative with starting a normalisation process. However, the commentary from recent Fed speakers of late really suggests the probability of ‘lift off’ by September should be higher than what is currently priced in.

What’s the trade?

Given conservative market pricing and my own view that rate hikes will commence in September, I feel selling rallies in three-month Eurodollar futures (September contract) into 9947.5 (the 6 March high) looks compelling. Trading three-month Eurodollar futures is possibly the purest way to play rate expectations and the likes of the dollar, gold and even the S&P 500 will move according to this market.

I would look to place stops above the 16 January high of 9955.8, while targeting a potential move lower to the 9920-9925 area. This would be a medium-term trade.

For traders who feel the Fed is going to be outright dovish and give little indication of acting this year, I would do the opposite and simply buy at market, expecting rate expectations for 2015 to be priced out (price up, yield down).

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