After months of blood, sweat, and tears, the Fed will have its last chance to make good on its plan to raise interest rates this year.
What exactly are market players expecting?
More importantly, how can you make pips from the event? Here are answers that might help you trade the event:
What’s the Fed rate hike hoopla all about?
Back in December 2015, the Fed pulled off a historic “liftoff” and increased its interest rates for the first time in a decade. Interest rates were pushed from below 0.25% to a range of 0.25% – 0.50%.
What surprised the markets was that the vote was unanimous AND the Fed upgraded its growth, employment, AND inflation projections. Talk about ending the year with a bang!
Fast forward to today and Uncle Sam is indeed in much better shape. Consumer spending is on the rise, the unemployment rate dropped, and consumer prices have risen. Heck, GDP growth for Q3 2016 even came in much better than expected!
The improvements have inspired speculations that inflation would shoot up too quickly, which is also probably why Federal Open Market Committee (FOMC) members have been hinting at rate hikes left and right lately.
But now we’re down to the last meeting of the year. With the Brexit vote and U.S. elections in the rearview mirror, Yellen and her gang have run out of excuses to make good on their plans to raise rates this year (they originally anticipated 3-4 in December 2015). Will the Fed finally walk the talk?
What makes you think we’ll see a rate hike this week?
At this point, NOT raising rates would have a more pronounced impact than an actual rate hike. The CME FedWatch Tool, a popular gauge of market expectations, showed that for an extended period of time, markets had priced in a 100% probability that the rates would be raised to the 0.50% – 0.75% range before its probability leveled off to 93.2% today.
And then there’s Janet Yellen’s recent testimony in Washington wherein she stated that a rate hike would be appropriate “relatively soon,” adding that postponing interest rate increases would necessitate abrupt rate hikes down the road and likely cause “excessive” risk-taking.
If a rate hike is a done deal, what could move the markets?
In a nutshell, investors will be looking for hints on how aggressive the Fed’s tightening would be down the road. Here are a couple of factors:
FOMC’s “Dot Plot”
For newbies out there, you should know that the Fed’s “dot plot” is a handy visual that hints at the voting members’ rough interest rate biases for the years ahead.
As of their September release, members are expecting at least two more interest rate hikes in 2017 though the FedWatch tool doesn’t price in a rate hike at least until June 2017. Anything more aggressive than that will likely push the dollar higher.
Changes in economic projections
Back in December, the Fed’s upward revisions to its inflation, employment, AND growth projections provided a bit more boost to the dollar’s upward reaction.
In its September meeting, the Fed shared that members are expecting GDP to grow by 1.8% in 2016 and 2.0% in 2017 and 2018 before leveling off to 1.8% in 2019. Meanwhile the unemployment is seen at 4.8% in 2016, 4.6% in 2017, and 4.8% in 2018 while the core PCE inflation is estimated at 1.7% in 2016, 1.8% in 2017, and 2.0% in 2018.
It should be noted though, that staff projections for the November meeting included downside adjustments to the 2016 GDP but higher growth forecasts for 2017 and 2018. Employment forecasts were also revised lower for 2016, while near-term inflation was revised higher.
The Trump effect
The Fed has taken care not to go repeat Mark Carney’s mistake of wading into politics heavily, but you can bet your next pips that Trump’s plans will factor in the Fed’s aggressiveness next year.
See, Trump’s tax cut and infrastructure plans are not only expected to boost economic activity, but it has already boosted the dollar and U.S. bond yields, which in turn made exports and borrowing more expensive. This kinda has the same effect as the Fed tightening its policies, so there will be less pressure on the central bank to tighten aggressively in the coming year.
How did the dollar react last time?
Even though a lot of people already called it, the Greenback still gained pips across the board when the Fed announced its rate hike in 2015. Interestingly, the move only lasted a day or two before the dollar lost all of its post-FOMC gains and traded lower near the end of the year.
As you can see on EUR/USD, USD/JPY, and USD/CHF’s 1-hour charts, the Greenback lost most of its pips even before the month ended. Heck, you can also see a similar reaction in the US Dollar Index! GBP/USD was a special snowflake though since it was still stinging from the “Super Thursday Part II” wherein the BOE basically nixed its hawkish biases.
What are the possible scenarios?
Rate hike + cautiousness
The most likely scenario is one wherein the Fed would indeed raise its rates by 0.50% – 0.75% but keep its projections somewhat closer to its September forecasts. Janet Yellen and her team will want to avoid being too hawkish to prevent aggressive risk-taking (for the dollar) or profit-taking (for U.S. equities).
Rate hike + hawkish bias
The Fed could also raise its projections on inflation, employment, and growth like they did last year. A dot plot showing more than two expected rate hikes would also reflect hawkishness that would likely push the dollar even higher.
Rate hike + dovish bias
Another possible scenario to consider is the Fed possibly taking cautiousness one step further and hinting that it’s done raising rates for a while and then resume making hawkish remarks as soon as they see more economic data. Remember that they will also be on a wait-and-see mode until Trump shares more details on his economic projects.
How might the dollar react?
A central bank rate hike is usually positive for a currency. However, the Fed’s rate hike has been speculated upon and priced into death since their September meeting.
The dollar also got an extra boost from Trump winning the elections, so there’s a possibility that most dollar bulls have already placed their bets. In fact, it’s likely that a lot of traders are waiting for the earliest opportunity to book profits before they close shop for the year.
Unless we see surprises from the Fed’s announcement that would hint at more than two rate hikes in the coming year, the dollar is vulnerable to buy-the-rumor-sell-the-news as well as end-of-year profit-taking scenarios.
You can bet your neighbor’s cat that trading newbies and pros across the globe will be tuned in to the event, so watch out for disruptions in your usual rate hike-currency correlations and keep an eye out for spikes in volatility! But if you’re not feeling like trading the event, then you can also stay on the sidelines and wait for a possible trading opportunity.