Tonight, at 1900GMT the Federal Reserve will announce its monetary policy decision which comes after two days of deliberation by the FOMC. The expectation is that this will be a groundbreaking announcement because the Fed is set to increase its interest rate for the first time since 2006. My title says that the FOMC “will” hike rates this evening. Now clearly nothing is a given in this crazy world of financial markets, however there is a strong suggestion that the FOMC will make its move and hike interest rates. I look ahead to what the Federal Reserve might do and also how the market will react.
Markets have got the timing of the Fed’s rate hike wrong on at least one (if not two occasions) this year (in September and arguably June as well), but this time it is different, right? Well if FOMC members’ rhetoric is anything to go by then this would seem to be the case.
What is the expectation?
According to CMEGroup FedWatch, the market is pricing in an 81% probability of a 25 basis points rate hike tonight. There are a few naysayers out there who are suggesting that the Fed should not make the move, but the market is certainly firmly on the side of a rate hike.
Time for a “dovish hike”
The timing of a hike was never going to be easy for the Fed. In the reasons behind the September “fake hike”, Yellen pointed to the international developments where China and the market turmoil prevented the move. Now we come into this December meeting and we see the oil price at multi-year lows (deflationary) with its indication for concerns over ailing global demand, and inflation still well short of the 2% target dual mandate target.
There are concerns that the US has a split economy. The industrial part of the economy is in recession, as likely to continue to be shown in the Industrial Production having fallen sharply throughout the year to lie around zero currently (and about to go negative today). Additionally, the regional Fed surveys show the manufacturing activity continues to contract. However, contrast this with 70% of the economy which is consumption driven and the consumer is seeing the continued benefits of falling oil prices. Retail Sales picked up in November and now even an uptick on CPI has set the Fed up nicely for a decision to hike.
My take is that the Fed will look at the labor market which is ready for a rates lift off, growth still around the 2% region and very early shoots of inflation. The committee has a credibility issue to wrestle with too, whereby forward guidance will be effectively dead in the water if they do not hike today. When will a perfect situation be to hike? It is almost now a case of if not now, then when?
So my belief is for a 25 basis point hike today (it is somewhat of an understatement in me saying that I am not alone in this…). However I also believe that the Fed is still inherently dovish in its voting structure. The real action is not likely to come with the rate announcement itself , but more with the release of the “dot plots” and also Janet Yellen’s press conference at 1930GMT.
Watch the “Dot Plots”
At the September meeting the dot plots showed that the Fed averaged around 1.500% for its end of 2016 rate expectations. That would suggest that going into the meeting, the committee is expecting another 4 possible rate hikes through 2016. For me this seems to be a bit much considering the unknown impact that raising interest rates will have. Also the move for the People’s Bank of China to peg to a basket of currencies could be seen as a move to further depreciate against the dollar (deflationary). I expect that the FOMC dot plots will pull back on the speed of the rate hikes. This would involve pulling the average down to maybe towards somewhere between 1.00% to 1.250% (i.e. two or three hikes in 2016).
Furthermore, Janet Yellen is a dovish central banker by nature and she will want to reassure markets rather than go into this rate hike like a bull in a china shop. The risks of a policy mistake must not be underplayed. Her language in the press conference is likely to be dovish and include something along the lines of “future rate hikes being data dependent” and “not on a pre-determined path”.
All of this will mean a rather “dovish hike”. (For reference, the September dot plot is below.)
How is the market going to react?
Well, that is not going to be a single answer. It is not simply going to be a case of one definite direction. Volatility will be a given, however the market could be pulled in different directions on firstly the rates announcement at 1900GMT and then there could be a second (and possibly opposite move) in the press conference at 1930GMT.
I think that we may see some dollar strengthening on the announcement of a 25bps hike at 1900GMT. However as I laid out earlier, i think that the dot plots and the press conference (and also probably the inflation expectations) are likely to paint a fairly dovish picture and this could drive dollar weakness or at least pare the gains that the dollar initially makes on the hike.
Volatility will therefore be the big winner tonight. The chart of EUR/USD is currently stuck between two major levels, with big support at $1.0810 and a big 50 pip band of resistance $1.1050/$1.1100. If what I have laid out comes to fruition we could see these levels still maintained, albeit with significant volatility for an hour after 1900GMT.
Key supports and resistance levels on key markets are laid out below:
- EUR/USD Support at $1.0810 Resistance at $1.1050/$1.1100
- GBP/USD Support at $1.4893 Resistance at $1.5335
- USD/JPY Support at 120.20 Resistance at 123.67
- Gold Support at $1046 Resistance at $1188/$1198