What to look for at the Fed meeting
The Fed is likely to hog the limelight this week. They’re all set to announce the first rate hike since 2018 but they won’t be hiking alone. All but the most dovish central banks are on the same path. It’s the speeds that differ.
Here’s a rundown ahead of the Fed meeting and what it could mean for markets:
The Federal Reserve is widely expected to raise rates by 25bps at this meeting. According to the CME FedWatch tool, traders are pricing a 96.3% chance of a 0.25% rate increase and just a 3.7% chance of a 0.5% hike.
This is way down from the 50/50 probabilities of a 50 bps hike seen before the Ukraine conflict and Powell’s subsequent comments to Congress.
Chair Powell said that the central bank would not want to add to the volatility at a time when geopolitical risk is already dampening risk appetites. Some have even suggested that were it not for the conflict, a 0.5% rate rise would have been more likely than not.
- In a Reuters poll (March 4th-9th), all 69 economists agreed that the Federal Reserve would hike by 25 bps at the March meeting. With such a clear consensus, if the Fed were to announce an unexpected (albeit improbable) 50 bps hike, it could catch markets completely off guard.
Presuming the Fed sticks to the expected playbook, the decisions announced at this meeting are unlikely to yield much in the way of new information. Markets will be keeping a far keener eye on Fed members' views of the future. One of the key questions:
How much support is there for a 50 bps hike at future meetings?
Rate of change matters. A series of faster/larger rate hikes could spook investors accustomed to high stock market returns underpinned by predictably low interest rates.
A smoother sequence of (for example) 25 bps at every meeting might be an easier pill to swallow.
The Dot Plot
Because this meeting also includes economic projections, the Fed’s dot plot will be published. This is not a formal forecasting tool. It simply shows where the majority of Fed officials see interest rates over the next three years.
This was how it looked back in December:
Three rate hikes in 2022, and another three in 2023. Nice and steady. But things change quickly…
This past month, Fed’s Bullard & Waller have both called for 100bps of hikes by July!
So it would be no surprise to see more than three hikes expected for 2022. There are six further Fed meetings in 2022 after this one. A 25 bps hike today and at each subsequent meeting would bring the Fed Funds rate to 1.75% by year end.
The longer run projections will also be important. This is the estimate of the interest rate peak. Often called the neutral or terminal rate. Will it be higher than the 2.5% seen in this dot plot? The higher that number, the more hikes are implied to reach it…
By most measures, the US economy is at or near the mythical ‘full employment’ level. If the new projections imply that the unemployment rate will be lower than the prior projections, this could embolden the Fed into faster rate hikes.
Last estimates showed the unemployment rate consistently at 3.5% throughout 2022, 2023 & 2024.
Will the projections show a downgrade to GDP growth estimates? From the last estimates:
- 2022: 4% GDP Growth
- 2023: 2.2% GDP Growth
- 2024: 2.0% GDP Growth
If the geopolitical situation is expected to impact economic growth, the Fed might be more cautious…
Inflation forecasts are likely to increase. The question is by how much…
Too high and investors might start to panic that the Fed will have to hike hard and fast to bring inflation down.
Down nearly 25% from the highs, trading below the 200 day moving average, and with recent rallies capped by the faster 20 day moving average. The Nasdaq 100 is generally considered to be more rate-sensitive than the S&P 500. How the tech-heavy index responds to the news and press conference could offer some early clues on how the market is interpreting the Fed’s stance.
It might be a little early to formally announce anything on this, although Fed officials are discussing the best way to reduce the size of their balance sheet. It currently sits at just under $9 trillion.
- Deutsche Bank analysts think the Fed could reduce their balance sheet by $1.9 trillion by the end of 2023.
- Goldman Sachs sees the balance sheet reducing to a little over $6 trillion in 2025.
There are two ways to do this. Passively and actively.
- Passively is known as balance sheet runoff. Basically, the Fed lets their assets expire and doesn’t reinvest the proceeds.
- Actively implies that the Fed would actively sell assets from the balance sheet each month.
In both cases, this equals a withdrawal of liquidity from the system.
Investor Stanley Druckenmiller famously said:
Earnings don't move the overall market; it's the Federal Reserve Board... Focus on the central banks, and focus on the movement of liquidity... Most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.
How about the dollar?
There’s a school of thought that as soon as the Fed starts hiking, the dollar will weaken. Essentially, the dollar rallies in anticipation (buy the rumour) of the hikes, and then once the event takes place it’s time to “sell the fact” and buy the laggards who’ll play catch up.
Sounds great in theory. In practice, it has worked in the past too. But it’s a tiny sample size. There simply haven’t been very many Fed tightening cycles to draw definitive conclusions from: 1994, 1999, 2004, 2015 & 2022 (TBC).
Germany’s ZEW sentiment survey today was very negative and highlighted the stagflation risks. EURUSD is still stuck in a descending channel.
Can the Fed decision prove to be a turning point for the single currency or will it add more fuel to the downtrend?
Not investment advice. Past performance does not guarantee or predict future performance.
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