The US Federal Reserve is expected to raise interest rates for the third time this year. Lately, USD has hovered near multi-year high. The greenback retreated slightly on the eve of FOMC but don’t be mistaken, the Federal Reserve will be very hawkish on Wednesday. A half point increase has been completely discounted and in the last 24 hours, expectations for a 75bp hike soared to 96% according to the CME’s Fed Watch tool.
A 75bp hike would be a technically and psychologically big move – the largest one time hike for the Fed since 1994. How the USD reacts will depend entirely on whether the central bank opts for 50bp or 75bp move. For the Fed, the question is whether inflation conditions are alarming enough for a drastic move that would inevitably crush the equity markets and heighten the risk of recession next year.
Consumer prices hit a 40 year high in May and the pain will continue as producer prices rise 10.8% year over year. Short and long term inflation expectations continued to climb according to the June University of Michigan consumer sentiment index. Both the Federal Reserve and President Biden have made fighting inflation a top priority. To put this into perspective, according to Moody’s Analytics, the typical U.S. household is spending about $460 more each month on the same basket of goods and services compared to last year. With oil prices hitting a 3 month high today, there are no signs of price pressures letting up. The Fed could get away with raising rates by 75bp tomorrow because the labor market remains strong with the unemployment rate hovering near its lowest rate since the 1960s.
The problem is that rising prices and rising interest rates means a rising risk of recession. According to a Financial Times poll taken last week (before expectations for 75bp rate hike surged) 70% of leading economists expected the US economy to fall into recession in 2023.
Their concern is that the speed and velocity of the Fed’s rate hikes would lead to a deeper contraction in spending and growth. Retail sales are due for release on Wednesday and a soft release would be a daunting reminder of the risks ahead. The recent drop in the personal savings rate to its lowest level since 2008 tells that Americans are already dipping into their savings to cope with rising prices.
Unfortunately according to 40% of the economists surveyed, 2.8% rates this year (which would be 50bp hikes in June, July and September) would not be enough to bring prices down. Traders are getting ahead of the game by pricing in 4% rates by the middle of next year.
Aside from the Fed’s decision on interest rates, economic projections and their dot plot will be released on Wednesday.
Analysts are looking for an increase in their CPI forecast along with a decrease in their GDP projections. Minimally, the dot plot should show their Federal funds rate projection rising from 1.9% in 2022 to at least 2.6%. The 2023 forecast should rise from 2.8% to at least 3.5%.
For Wednesday’s FOMC announcement, there are two catalysts for big moves in currencies, equities and Treasuries. The first being the rate decision will be accompanied by the economic forecasts and dot plot. The dot plot will provide some guidance on future policy path but the extent of the Fed’s hawkishness may not truly be known until Chairman Powell delivers his press conference.
When it comes to trading FOMC, there is usually a knee jerk reaction to the announcement and this month the reaction will be significant. Then a retracement followed by consolidation about 10 to 15 minutes after the initial move before a real more durable move about 15 minutes after Fed Chairman Powell delivers his prepared comments.
However if they only raise rates by 50bp instead of 75bp, even if they intend to continue tightening consistently over the next few months, USD should sell off in disappointment. However, with a clear aggressive path of tightening still ahead, the USD pullback will be short-lived.