Markets are convinced that the Fed will cut rates at the conclusion of the FOMC meeting on Wednesday. Market volatility could be caused by surprises in the accompanying statement or in Chair Jerome Powell’s Press Conference. The market is expecting another rate cut in December, but the Fed’s rhetoric could shift the odds and move dollar pairs.
The issue the Fed faces is inflation above target while the economy shows signs of slowing, which means that the outcome of the meeting will hinge on whether the jobs market or inflation is prioritized. To further complicate that scenario, the government shutdown has prevented the release of the latest jobs figures. That means the FOMC members will have to guess based on incomplete information, which will affect how the market reacts.
What are the Odds of a Cut?
Futures markets are pricing in a 98% chance of a 25bps cut, suggesting there will likely be little market reaction if the Fed meets expectations. The main doubt is at the December meeting, where the market sees a 90% chance of another 25bps cut.
If the Fed provides more dovish language, then the market could raise the odds of a December cut and weaken the dollar. But the difference is relatively small, suggesting that the likely dovish scenarios don’t imply much downside for the dollar. On the other hand, if the Fed were to imply somehow that it will pause at the December meeting, there would be more room for a hawkish surprise. This could temporarily support the dollar.
What About Quantitative Tightening (QT)?
The other issue is that the Fed is widely expected to end its QT program, which shrinks its balance sheet. Ever since the Fed started hiking rates, it has been selling the government bonds it holds to drain liquidity from the market. But a couple of weeks ago, banks began dipping into emergency liquidity reserves through the repo market. That set off alarm bells among analysts, who worried that the stock market could face a liquidity crisis. At the time, the Fed all but said it would end the balance sheet runoff at the October meeting, reassuring investors.
The QT program is understood to have an effect similar to 25 bps in interest rates, meaning that the market will likely see the end of QT as easing on top of the rate cut. The question is whether FOMC officials see it the same way and conclude that they should wait to see how the market reacts for one more month. That could explain why the Fed might be more hawkish this time around than the market expects.
What to Look Out For
Traders will be looking for confirmation that the Fed will not only cut in December, but keep easing through the early part of next year. This is predicated on the expectation that the Fed is more concerned with the labor market than with inflation at the moment. Therefore, the market will likely be looking for Powell to suggest that the jobs market is weak and that the Fed is concerned about economic growth.
If the Fed appears to be more concerned with inflation, then it could be seen as a hawkish stance. At the last meeting, the Fed mentioned that risks were both to the upside and downside, a point that Powell repeated in his press conference. If that kind of language is repeated, then the market reaction could be minimal.
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