FOMC Preview: What To Expect?

The puzzle is not easy to put together by the Fed, and that’s why it may result in today’s FOMC meeting to conclude that not only a 25bp rate cut was needed as an insurance, but amid such dicey global backdrop and low inflation, it’s best to keep sufficient dovish options on the table.

The US Dollar is going to command the attention of the whole financial system as the Federal Reserve is just hours away from updating its setting of monetary policy.

According to the Fedwatch tool by the CME Group, which looks at the probability of an FOMC move on rates, the overwhelming assumption is that the Fed will execute on its well-telegraphed rate cut, but only by a reduction of 25bp, currently standing at a 78% chance vs 50bp, which is assigned a 22% probability only.

Today’s FOMC represents a historical meeting, given that if expectations are ratified by Powell & Co., it will be the first time since 2008 that the Fed will lower interest rates, in what’s been dubbed an ‘insurance rate cut’ to better accommodate the tight US monetary policy to a gloomier global outlook amid low domestic inflation.

Fed Cut Represents A Historical Event

It’s important to note that when the Fed officially concludes a tightening cycle, as it’s more likely to be the case in a few hours’ time, it marks a meaningful top and sets the Central Bank out for what’s historically been a prolonged period of lower rates. Therefore, if history is any indication, today’s landmark moment to return to an official easing, even if still debated as a one and done rather than the commencement of a rate-cutting cycle, it runs the risk of morphing into one.

The chart below doesn’t lie. The Fed has nailed it over and over in dialing back to an easing cycle as it forebodes signals of distress in the financial system. However, this time, rather than originated by internal US economic factors, the Fed’s rationale to act lies on waning global slowdown as the dicey trade war takes its toll on business investment intentions (CAPEX) at a time when we see convergence in the overmaturity of both the business and economic cycles in the US.

But it gets more spooky, even if at this point is just anecdotal evidence. The last three recessions all took place within 3 months of the first-rate cut after a hiking cycle.

Akin To The ECB, The Market Has Set A High Bar For The Fed

But I digress. Today, which is what really matters, we need to deconstruct what and how the Fed does in order to gauge the potential ramifications for the US Dollar.

An event that’s probably raised some red flags by Forex traders is the fact that the US Dollar index (USD vs G8 FX) has put on its largest winning streak (8 days) this year, just ahead of the FOMC fireworks. This dynamic is the exact reverse of what we saw last week in the EUR index (vs G8 FX) if you think about it. 

Ahead of the ECB, the EUR index had sold off mercilessly for over 2 weeks in anticipation of a big dovish announcement by the ECB, which never came in the degree expected, as the CB failed to flesh out the necessary QE II details the market was waiting for to justify further downside.

In the case of today’s USD lofty valuation, the pre-FOMC run tells us that just as the bar was set high for the ECB to keep the bearish party going, the Fed is going to have to cut the wings from those perma dovish by hinting that this is not a rate-cutting cycle (for now) and probably dismiss the immediate prospects for more cuts in Sept. 

At present, there is certainly a disconnect between what the market is discounting and reality. According to market pricing, the Fed is contemplating 100bp of rate cuts by the end of 2020, but the logic seems to defy such action in the very short-term. The bond market thinks Trump’s pressure on the Fed and his trade policies will result in an easier Fed, which in and by itself has proven, along with stock valuations, to be a signal for the Fed to act in what’s seen as “a hall-of-mirrors situation.”

Fed's Dot Plot To Initiate Today's USD Valuation

A first crucial clue will come out of the Fed’s update dot plot graph, which is the method used to convey each member’s benchmark Federal Funds interest rate outlook going forward. How the dots gets re-distributed will have a first initial impact on how the USD react.

What will be important to watch is whether or not the Fed’s dot plot under or over-delivers in its forward guidance. Therefore, if the Fed decides to cut rates by 25bp and that happened to be a unanimous decision, we could initially see a modest USD rally as the market interprets that as a sign that there is a low conviction on delivering a second rate cut at this point.

What would really turbo-charge the USD is if the Fed cuts by 25bp but a minority of the members disagreed by voting to keep rates unchanged. That’s not my central case though, as the line-up of Fedspeakers in July has really carried a consistent message about a small cut. Both Kansas City Fed President Esther George and Boston’s Rosengren have expressed their opinion against cutting rates, and if anyone else joins, it will cause more uncertainty (USD+).

Now, if the Fed wants to practice a major harakiri by committing the suicidal decision of not cutting rates, not only it’d represent an epic failure in communication, but the USD would go absolutely ballistic. This is a scenario the market finds as having nil probabilities and I agree.

On the contrary, if a few members dissent by endorsing a 50bp rate cut, which at this point, judging by the raft of Fedspeakers in the last month, looks quite unlikely, then the potential initial move by the US Dollar would be to pull back from the elevated levels it trades from.

A scenario that should not be ruled out, as the 22% Fedwatch tool demonstrates, is that the Fed does indeed cut rates by 50bp, which is the central case defended by Morgan Stanley’s Research Team. “The worry lies in the US' sharply weakening capex cycle” they note. “We believe that the Fed will be concerned about capex weakness and its impact on productivity/neutral rates, among other solid reasons for our 50 bp rate cut call.” If it turns out to be true, the USD would collapse.

In my opinion, the risk appears to be skewed towards under delivering and USD longs added. This is a thesis that is predicated on the basis of paying attention to all Fedspeakers in July.

To portray the overall sentiment at the Fed, I find it quite revealing that when a perma dovish like Fed St. Louis President James Bullard has ruled out support for more than 25bp this month, really makes you question how on earth we’d get aggressive rate cut calls in near term.

Add to the mixture of reasons the solid US economic data in recent weeks (US NFP, retail sales, core durable goods, US ISM, …) and it fortifies the notion of the Fed under-delivering.

Fed's Powell Intervention To Set The Real Tone In The USD

But the largest concentration of volatility should come as Fed’s Chair Powell gives his speech and answers journalists’ questions on monetary policy. Since no one really knows how Powell will play his hand on such a high wire act, the communication around how likely it is that further rate cuts follow suit is crucial, and here, I believe the Fed is in no position to commit at this stage.

My sense is that the Fed wants to cut more as it recognizes the current interest rate level is out of whack with the perceived neutral rate. The unprecedented shift in the Fed rhetoric into a dovish stance at a time of above-trend economic expansion has found its roots on the anticipation of the knock-on effects of the global troubles to the US economy, hence it has grown uncomfortable with the backdrop seen for the US to keep up its growth momentum.

Jerome Powell has been quite vocal alongside his closest confidants Fed’s Clarida and Williams that lower rates are coming due to “uncertainties around trade tensions and concerns about the strength of the global economy continuing to weigh on the US economic outlook”.

In the Fed view, there are many moving pieces and uncertainties that warrant caution but with the US economy still on a stubbornly solid footing, and the trade war in a bit of a recess as US-China feel each other out on the truce, they must be prepared to act further at any time.

What this means is that for Powell to contain volatility and the rise in the USD, he has to play a bit of an ambiguous role by providing enough evidence, as a unified front, that the intention is not to embark on protracted lower rates, but still affording to sneak in enough of a hint for another 25bp cut in September or October. That expectation should cap the USD.

If the Fed is serious about doing something to minimize future risks in the US from external factors plus contribute to keeping inflation firmer, I don’t see how a 25bp rate cut will cut it, let alone that the onset of a rate cut phase barely ever is followed by just a one-off as I mentioned at the beginning of the article. It should be reflected by a hint of a follow-up 25bp cut.

If Powell, instead, resorts to a conditional stance with flexibility as the central rhetoric to adapt to developing economic conditions without making the case for further cuts in Sept, that might not serve too well to USD bears, and the cost of that would probably be pretty sizeable in terms of the downside in the US stock market. Financial conditions would probably tighten too.

Powell will get leverage by leaving the door open to act near-term if needed, but the markets aim for meat in the bone (read reassurance), that the Fed wants to bring the interest rate lower by at least 50bp before re-assessing. It should force them to promise something more.

And that reassessment, in large part, will come down to how Trump plays its trade policy card, to how fast a global slowdown can spread into the US economy, to the levels high levels of the USD which may create further disinflationary pressures and keep missing the Fed target inflation, to the attractiveness of keep investing by businesses in the US, etc.

The puzzle is not easy to put together, and that’s why it may result in today’s FOMC meeting to conclude that amid such dicey terrain, it’s best to keep sufficient dovish options on the table. That’s why I still think it’s in their best interest to pre-announce further action in Sept or Oct, which in my opinion, should put a cap on the rise in the USD short-term.

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