The general expectations among economists and the market are that the Fed will keep rates unchanged at the end of its two-day meeting on Wednesday. However, there is a lot of uncertainty, particularly around the outlook, which could mean the market reacts strongly to the decision or to Fed Chair Warsh’s press conference afterwards. As the geopolitical situation cools a bit and bond yields rise, the rate decision could be the week’s biggest market mover.
Futures markets see the odds of a hold at around two-thirds, with the other third expecting a hike. This implies that if the Fed delivers on expectations and keeps rates unchanged, the market could still react. But that reaction could be offset by the statement and, perhaps more crucially, by Warsh’s commentary.
The Fed Interest Rate Trajectory
The main issue for the market is that the odds of a hike at the September meeting are over 80%, so there is a broad expectation that the Fed will deliver a “hawkish hold”. That means Warsh is expected to lay the groundwork for a rate hike at the next meeting, similar to what Lagarde did last week. In that case, the market reaction would likely be minimal, particularly for the EURUSD pair, as it would keep the rate gap unchanged.
However, the market is fairly hawkish in its outlook, and barring a hike on Wednesday, there are few options to exceed expectations for future tightening. On the other hand, there are many ways that the Fed could deliver a dovish surprise, from the wording of the policy statement to Warsh’s commentary.
The Data Doesn’t Back Data-Dependency
US macro data has weakened since the last FOMC meeting, with cooler-than-expected inflation, core CPI actually falling and a much weaker June jobs report. Despite this, the market actually increased its expectations for hikes, going in the opposite direction of the data. Warsh has been making pains to emphasise that the Fed will be more data-dependent and less tied to forward rate guidance. This is producing a disconnect between the market and the Fed.
At the same time, Warsh has been using harsh rhetoric against inflation. The market seems to be believing Warsh’s rhetoric more than the data, setting aside the fact that he was appointed by the notoriously dovish President Donald Trump. The market oversold the effect that higher energy prices might have on inflation, and might have gone a little overboard with its hawkish expectations.
What to Look Out For
There are three main things traders will be looking for that could shake up the market. The first is the decision itself, and the unlikely event that there are dissenting voters. Those votes would likely be for a hike, which is one of the few options in which the Fed could be more hawkish than the market expects. That would likely shore up the dollar but weigh on gold and the EURUSD.
The second is with the policy statement that comes out concurrently with the decision. If that retains its focus on inflation, then the market will likely maintain expectations for a September hike. But any mention of a softer economy or jobs is likely to prompt a dovish market takeaway, weighing on the dollar and boosting gold and EURUSD. Finally, Warsh could adopt a more dovish tone at his post-rate-decision press conference. A possibility is a bit of confusion, as the market is expecting a solid signal for a rate hike in September, but Warsh is averse to giving forward guidance.
