The FOMC’s main job this week is to set the parameters of its “insurance” cuts. As Powell, Williams and others have recently made clear, the FOMC is about to cut rates despite historic tightness in the labour market and steady wage growth.
The rationale given, is that the medium term inflation outlook remains unsatisfactory, and global factors have worsened the balance of risks to the economy.
As a result, lowering rates now mitigates some of the downside risk to the inflation outlook, but carries little cost or risk due to muted inflation.
The Fed’s own take on insurance cuts is one thing. Market pricing of the Fed path is entirely another.
OIS, Futures and treasuries pricing suggests a deeper and steeper path than we think the FOMC is actually likely to deliver.
OIS forward, for example, are pricing 68 basis points of cuts by the Fed’s fourth future meeting in December, and even a possibility of a 50% cut this week.
This is difficult to square with current US data: some manufacturing surveys have followed global indicators downwards in recent months, but in general the US economy remains solidly in growth territory and the labour market continued to go from strength to strength.
The FOMC was hiking on the basis of its medium term inflation outlook as recently as last year, so to justify cuts of this scale based on its current assessment the FOMC would need to fulfil one of the following:
- Admit its medium term forecasts in 2018 were hopelessly wrong – and explain how they can have so much faith to the current medium term forecasts when the last lot were so off? Why isn’t conservatism a better approach than a sharp proactive cut cycle?
- Outline a complete change in its approach to inflation targeting where the FOMC is far less concerned about upside inflation risk and focusses on running a hot labour market.
Instead of one of these two sweeping changes, we believe the FOMC is far more likely to cut on Wednesday while carefully reserving the right to stay data dependent.
This is likely to be an upside risk for the dollar, particularly regarding expectations of a third cut this year.
Chart: OIS Forward Pricing of next 4 FOMC meetings
30bp – slightly more than one 25bp cut – is priced in for this week’s meeting. The other interesting aspect of the curve is that a third cut is almost fully priced in by December. This week’s meeting is likely to challenge this expectation, introducing upside risk to the dollar.
A potential revaluation of FOMC risk would be particularly interesting for pairs like GBPUSD and EURUSD, which remain just above significant lows.