FOMC Preview: The Fed’s Christmas list

<p>For the typically lackluster mid-December time period, most major markets are still relatively liquid and volatile, and traders continued engagement can be chalked up almost […]</p>

For the typically lackluster mid-December time period, most major markets are still relatively liquid and volatile, and traders continued engagement can be chalked up almost entirely to tomorrow’s landmark FOMC decision. As you’ve no doubt heard by now, traders and economists expect the central bank to raise interest rates for the first time since June 2006, nearly a decade ago.

As NPR noted in a recent article, the last time the Fed raised interest rates, none of the following even existed: Twitter, the iPhone and iPad, Netflix streaming. Conversely, many of megabanks that would have been impacted by the interest rate hike have since gone out of business, including Lehman Brothers, Bear Stearns, and Washington Mutual. Indeed, many younger traders and financial and professionals haven’t seen a single interest rate increase in their careers.

So why are market participants so convinced that the Fed is ready to embark on an historic path by normalizing interest rates in the post-QE era? Beyond the obvious improvements in economic conditions, the expectation comes straight from the horse’s mouth. Earlier this month, Fed Chairwoman Janet Yellen noted that, “Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.” When it comes to so-called Fedspeak, this is about as clear of a signal that a rate hike is coming as any, and traders are pricing in an 81% chance of a hike as a result, according to the CME’s FedWatch tool.

For traders though, there’s much more to tomorrow’s festivities than the Fed’s interest rate decision alone. Much like procrastinating holiday shoppers, traders will have to visit a number of different locations in a short period of time tomorrow in order to have a successful period. In that vein, we’ve created a “Christmas list” of Fed-related events to watch tomorrow:

1)      The interest rate decision (14:00 ET, 19:00 GMT)

Like buying a good gift for your wife (speaking of which, I need to get to the store ASAP), traders should first verify that the Fed does in fact raise interest rates as expected. While we don’t expect any surprises on this front, especially after the central bank has painted itself into a corner where it risks losing credibility if it doesn’t hike, there’s still an outside chance that the Fed could be spooked by the recent turmoil in the commodity markets and hold off. For the sake of completeness, we’ll noted that the dollar would likely crater along with interest rates, while stocks could rally, if we see this unlikely scenario.

2)      The monetary policy statement (14:00 ET, 19:00 GMT)

After verifying the interest rate decision, traders will key in on any changes in the accompanying monetary policy statement. After this month’s strong NFP report, we expect the Fed to upgrade its assessment of the labor market. The wildcard here will be any change in the central bank’s comments on inflation; the cautious comments about “monitoring inflation developments closely.” If this line is removed, it would reflect a more optimistic view on the US economy and could benefit the US dollar at the expense of stocks and bonds.

3)      The summary of economic projections (14:00 ET, 19:00 GMT)

This chart will provide some teeth to the statement’s vague comments. If the Fed members ratchet up their expectations for core inflation (last estimate was 1.7% in 2016) and economic growth (last estimated at 2.3% in 2016), or lower the anticipated path of the unemployment rate (from 4.8% at year-end 2016), that would be seen as hawkish. Of course, the infamous “dot chart” of interest rate expectations will be closely scrutinized. Back in September, the median FOMC member anticipated we’d see six(!) interest rate increases to a 1.5-1.75% range by year-end 2016, though that estimate is almost certain to come down. However, if the dots still coalesce around a 1.25-1.5% range though, the dollar could catch a bid on the expectation of a more-aggressive-than-expected rate hike cycle next year.

4)      The press conference (14:30 ET, 19:30 GMT)

Once traders have had a chance to digest the decision, statement and summary of economic projections, Dr. Yellen will take the stage to throw another spanner in the works. It’s in these comments that most traders expect to see evidence of a “dovish hike” or “one and done” scenario. In other words, the market expects Yellen to stress that the Fed will be raising interest rates very gradually moving forward. While we agree that dovish commentary is the most likely scenario, there’s also an outside chance that the Fed will be more optimistic than many expect. If Yellen implies that another rate hike is on the table in March, for example, the dollar could catch a bid as traders update their interest rate path expectations.

5)      The market reaction

As always, the market’s reaction will serve as a critical sign of how traders are positioned. If we do seen the expected dovish hike, a “buy the rumor, sell the fact” scenario seems to be in play for the US dollar, although the pullback over the last two weeks could mute that type of move. Conversely, a more optimistic view from the Fed could boost the dollar back to its recent multi-year highs and send interest rates rocketing.

Clearly there’ll be a number of moving parts for traders to watch in the condensed period tomorrow afternoon – we’ll be out with an instant analysis piece as soon as possible after (and maybe even at the end of) Yellen’s press conference.

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