As the FOMC blackout period rolls on, market participants continue to ask if the current Fed pricing is too aggressive as the dollar begins to trade in a tight range in the run-up to next week’s main event.
It all started with comments from St Louis Fed’s Bullard on the 3rd of June. Bullard highlighted that the fall in inflationary pressures could be more permanent than the Fed previously anticipated.
The initial rumblings of a rate cut confirmed the markets preconceptions, playing into the narrative of a slowing US economy as the effects of the Trade War with China start to take their toll.
Bullard’s comments compounded concerns from non-voting members of the Fed such as Barkin and prompted a significant repricing in Fed Fund futures, US yields and the dollar.
However, the aggressive shift in market expectations looks overstretched, especially given the blurred economic outlook and uncertain trade policy, meaning July’s meeting could surprise markets to the upside.
Trade uncertainty has definitely played its part to date in the Fed’s assessment of the economy thus far. With Wednesday’s meeting occurring in the run up to what is building to be a pivotal G20 summit at the end of the month, the central bank’s interpretation of patience is more crucial now than ever before.
However, Trump’s crusade to renegotiate trade deals isn’t the only uncertain dynamic in the Fed’s outlook with the recent bout of economic data continuing to paint a mixed picture of the US economy.
Spot forecasts of Q2 GDP suggest a slowdown in growth below the 2% level, but part of the slowdown is expected as the US economy moderates back towards its trend growth level.
Meanwhile, business optimism and labour market data remains resilient despite the recent nonfarm payroll wobble and increase in trade tariffs.
Monex base case
With the G20 summit on the horizon, mixed economic data feeding into the market, and core inflation showing signs of stabilising as per the latest CPI release, we expect no change in the current policy stance despite Fed officials confidence in the economic outlook to have taken a knock.
However, a more pessimistic Powell in the press conference is likely given the mounting downside risks. Voiced concerns over falling inflation expectations, inverted yields and slowing global growth would undoubtedly keep the prospect of rate cuts on the table for the rest of 2019.
By holding rates within the current range, the meeting could send hawkish ripples across markets due to expectations assertively pointing towards a 25 basis point cut in the lead up to Wednesday’s meeting.
Chart: Fed Fund futures point towards a 65 basis point cut in rates by January 2020
By allowing more time for the data to develop the Fed runs the risk of the latest policy decision being regarded as a mistake by markets, with the move itself stoking fears in riskier assets as US yields start to climb back towards previous levels.
We believe the normalisation of looser financial conditions are warranted globally given the deteriorating economic climate, and expect the Fed to begin easing again in Q3 2019 with a total reduction in the policy rate of 50 basis points this year.
Should the Fed hold rates on Wednesday, the repricing of market expectations are put on ice will likely rock emerging market currencies and prompt a bout of temporary dollar strength.
High beta currencies such as ZAR and MXN are in the immediate line of fire, while the current dovish stance by the ECB suggests there is plenty of room for EURUSD to trend lower in the aftermath of the meeting.
However, one cannot rule out the potential for conservatism to be thrown out the window and for the Fed to bow to market expectations, although this scenario remains a tail risk in our opinion.