FOMC preview – the market wants clarity

The market is putting the probability of a rate hike at this Federal Reserve meeting at 20%.

Federal Reserve
Source: Bloomberg

It’s worth putting perspective around this rate hike - since the early 1990’s, with the exception of two meetings in 1994, the Fed has only raised rates when the implied probability of a hike (discounted into markets) was above 70%. If we focus on December 2015 when it last hiked rates, the market had the prospect of the move at 91%, despite some shaky economics at the time

So given the current pricing in the interest rate markets, a hike today would represent a huge surprise and likely cause a strong USD rally, which when accompanied by a strong sell-off in US treasuries would represent a sizeable tightening of financial conditions and knock confidence. One would therefore expect global equities, especially emerging markets to be sold aggressively. The key for me though is how ‘real’ (ie inflation adjusted) bond yields react to the Federal Open Market Committee (FOMC) statement and Janet Yellen’s press conference thirty minutes later. If bond yields move higher without inflation expectation also increasing, then one would expect a strengthening of the USD.

The market is just not positioned for a hike today and it is certainly are not positioned for a pick-up in volatility.

My own personal view, in-line with consensus, is that the Fed will use this meeting to communicate that it is looking very intently at hiking in December. I have argued that US data and inflation expectations are just not strong enough to warrant a rate hike in 2016, but we can’t underestimate the will of the US central bank, which clearly wants to raise. It therefore needs to guide the market to a greater probability of a December hike from the current 55% that’s being priced in.

One also suspects that if it does guide to a December rate hike, it will accompany this with fairly cautious language. The last thing it wants is to be the cause of panic in global markets and a USD rally would clearly not help anyone given the massive levels of US dollar denominated debt that emerging market corporates have binged on over the years. Even if it guides to a hike, don’t expect the USD to rally significantly.

The Fed will also provide new economic projections and as has been the trend among all central banks, one suspects its prior forecasts from the June meeting will be lowered. It would not be a surprise to see a revision from 2% to 1.7%-1.8% for 2016 GDP forecasts, although its forecasts for inflation and unemployment should remain as they were. For the first time we get GDP, inflation and employment projections for 2019.

The perversity of the situation is that if the Fed hold off completely and give no indication of a December hike, it could cause worries in financial markets and cause equities to sell-off, with traders questioning whether the Fed is genuinely concerned with the outlook of the US and global economy. Nothing is ever easy in trading, but the tone of the statement is likely to be a really important aspect. How upbeat or pessimistic will the US central bank be? That could be the most important aspect.

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