Investec FX - US FOMC - FED up of waiting


The Fed Funds futures market is currently pricing in a 78% chance of a Fed interest rate hike tomorrow, the first hike since June 2006.

The Fed looking likely to hike

  • The Fed Funds futures market is currently pricing in a 78% chance of a Fed interest rate hike tomorrow, the first hike since June 2006.
  • This is in-line with improved US data, particularly job gains that have put the unemployment rate within the Feds’ estimate of the long-run range 4.9% - 5.2% (part of the Fed’s dual mandate)
  • Fed rhetoric has signalled an intention to raise rates in 2015 with December specifically referenced within the October FOMC statement and unusually quoted as a ‘live meeting’ for a rate decision.
  • Fed Chair Janet Yellen stated earlier this month that economic data had met the Fed’s expectations, suggesting a hike is more or less a done deal.

Oil prices pose a risk

  • The lingering risk of a lower oil price continuing to drag inflation lower across the pond (the other part of the Fed’s dual mandate) has intensified in the last couple of weeks. Fed rhetoric is usually based on the assumption energy prices will stabilise or rise, so this is providing some tail risk.
  • The recent OPEC meeting saw the oil exporting group disappoint markets by dropping their production target altogether (against a hoped of supply reduction), sending oil prices crashing to new multi-year lows and causing a niggling risk of a Fed U-turn (although this is certainly not the central case).
  • To date, the Fed have seen the deflationary pressure of falling oil prices as ‘transitory’. Any change to this view, that lower oil and energy prices are here to stay, could see the Fed change tact.

A hike is less important than the path ahead

  • On the assumption the Fed will raise interest rates across the pond by 25bp tomorrow, the more important issue will be the amount and timing of further hikes in the USA.
  • Every quarter (at alternate meetings) the Fed publish a ‘dot plot’, where each member anonymously places a dot to show their expectation of where interest rates will be at the end of each year going forward. At the last ‘dot plot’ in September, the Fed were on average expecting to raise rates 1% per year, much more than current market pricing.
  • The latest ‘dot plot’ will be released tomorrow at 7pm along with the statement, and will likely be key to future US Dollar sentiment.

A ‘Dovish hike’ seems central case

  • Many analysts believe the Fed will deliver a ‘dovish hike’. Under this scenario the Fed would raise interest rates while delivering a very dovish tone, likely by reducing their expected rate path (dot plot), and perhaps talking down the pace of rate hikes at the accompanying press conference, starting at 7.30pm.
  • This could be achieved if focus is on downside risks to the inflation and global backdrop, but the risk is that the market currently has much less priced in than the previous ‘dot plot’, so even a ‘dovish hike’ may be more than current pricing reflects.

Historical US Dollar moves

  • Many commentators have highlighted that under previous scenarios where the Fed has raised interest rates for the first time in a low rate environment, the US Dollar has strengthened into the meeting with expectation, and then weakened post-meeting.
  • This ties in with current market moves, where the US Dollar has seen substantial strength across the board in the build up to a potential rate rise. Indeed the Fed’s own Trade weighted dollar index is up 10% year to date.

‘This time it’s different’?

  • As mentioned, currently the market has priced in a very gradual path for future US rate hikes beyond 2015.
  • The Dec’ 16 Fed Funds future is implying interest rates at 0.78%, the dot plot in September (already dovish after a China stock rout in August) had an average closer to 1.5%. This divergence continues along the curve.
  • Unlike previous situations, even a toning down of the Fed’s expected future rate path following a first hike could see the market still needing to catch up pricing in future rate hikes, this means we could well see further US Dollar strength after the whip-saw moves finish and the dust settles in the weeks and months ahead.

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