FX Trading focus: The Fed expectations conundrum
The market pricing of Fed rate expectations next year, relative to actual developments over the last couple of weeks has been far from straightforward. The cause and effect was initially logical as Fed rate expectations were jolted higher by the 6.2% October CPI print on November 9th and then by the more hawkish turn from Powell and Brainard in their acceptance speeches just under two weeks later. But subsequent developments have failed to take us to new highs for the cycle on where the Fed Funds rate will end next year. Sure, the omicron variant news that broke on November 26 was a key contributor to derailing the trend higher in expectations, but since then we have had relatively encouraging news on the omicron front, we have had Powell out in testimony before Congress making it even more clear that a hawkish shift is coming, we have a US economy that is so hot the output gap is probably verging on negative, and we had an even higher 6.8% November CPI print just last Friday. And here we sit with expectations at lower levels then where we were at the end of the day on November 22nd, the day of the surprisingly hawkish Powell and Brainard acceptance speeches, and some 11 basis points from the cycle high. What gives?
I have strong doubts that the issue is the omicron uncertainty touted in headlines and market commentaries, but could be wrong at the margin there. There has thankfully been nothing yet in the news flow on omicron that leads me to believe that we will see sustained impact from this new variant. The current ugly covid reality on the ground in Europe has mostly to do with the delta outbreak’s aggravation from cold weather.
As I am not at all sure what the Fed will deliver tomorrow and how the market will react, I will take a couple of stabs at first, what the Fed will likely deliver and then how the market, given what is implicit in forward expectations and other factors, will react to these scenarios (further below).
- The dovish case (low probability) I have a very hard time seeing the Fed under-delivering relative to expectations, as the whole intent here has to be to at least meet the market at where it is priced, given the new tone. What would this look like? Some weird partial acceleration of the tapering and dot plots that don’t quite meet the market expectations for 2022 or 2023, perhaps. Don't want to dwell on this scenario...
- The base case scenario (60+% odds) this is one in which the Fed delivers a doubling of the speed of tapering by $30 billion as of this meeting, which puts it on schedule to zero balance sheet expansion by mid-March next year. The policy statement crystallizes the hawkish shift that has recently been made clear and includes watered down versions of the hawkish scenario below (keeping rate lift-off language a bit hazy so we don’t know whether to bring a March hike fully into view, a last residual sign that it is afraid of its own guidance, a dot plot that meets the market expectation at the median, etc..)
- The hawkish case (30%+ odds, and what I hope they deliver) the Fed delivers a doubling of the taper speed or faster (hinting that it wants it done ASAP) and sufficiently credible language on the timing of the lift-off to clearly bring the March FOMC meeting into view as a possibility. It will be important for the Fed to eliminate as much forward guidance as possible to really look hawkish and suggest merely that it is going to react to conditions as required. This could also be achieved in part with lots of dispersion in the dot plot forecasts for 2022 and 2023 to make it look as if the Fed can see a wide range of outcomes, depending on what is justified by incoming data and conditions on the ground.
Now for the more difficult bit: the market positioning and reaction function to what the Fed delivers. The conundrum going into this FOMC meeting is first, how low the market expects the Fed rate hike cycle to peak (well below 2.0%) and to how it would react, both in rate, USD and risk sentiment terms to the above scenarios. There is actually precedence for quite low Fed expectations on initiation of a rate hike cycle. Back in December 2015, when the Fed delivered its first post-GFC rate hike, the three-year forward Fed expectations were also around 2.0% for the Fed’s terminal rate. These quickly collapsed to 1% in early 2016 when Yellen was forced to bow to the risks of a very strong US dollar, and only recovered in a bigger way in the wake of the 2016 election, when the market anticipated Trump’s powerful supply-side stimulus. If the Fed delivers hawkish, we will likely have to see actual rate expectations shift to new highs for the cycle to get a strong response from the US dollar after the meeting.
The bearish interpretation for the US dollar and the economic outlook is that US 10-year yields are still stuck well below cycle highs at 1.43% and Fed “terminal rate” expectations are stuck below 2.0% because the market believes that the Fed will simply be unable to get very high with its policy rate before crushing either financial markets or the economy or both, barring new developments perhaps on the fiscal front. On the latter, a significant “fiscal cliff” is much feared next year, even if the full Build-Back-Better stimulus is passed before year-end. For any solid further demand-side pickup to develop from here, we would need to see solid consumer dis-savings and a new credit cycle engaging, theoretically possible given healthy private debt levels and a hefty savings built up during the pandemic.
A more benign interpretation is that low rates are obscuring what the Fed might do because the US market is still swimming in liquidity, even with the QE tapering already in the bag. Let’s recall that the Fed’s reverse repo facility is a kind of “stored QE” and has grown again this week, standing at $1.6 trillion as of yesterday, suggesting an ongoing significant hunger for US treasuries that may be far more about safely parking liquidity rather than anything to do with the Fed or the growth outlook. The scramble for treasuries could continue even on a hawkish Fed into year end if some of the bid for treasuries is due to the large US financial institutions (G-SIFI’s) doing all they can to shrink their balance sheets into year-end to avoid size-linked penalties. This may have been the case last year and note that long US yields exploded higher in the first week of this year.
EURUSD creeping back higher as Fed expectations have crept lower over the past couple of sessions The upside scenario would require the FOMC meeting to fail further jolt Fed expectations to new highs for the cycle, with or without a hawkish shift, and then the ECB is forced on Thursday to capitulate after a fashion to the risk of rising inflation and even the vaguest rhetoric points to an eventual end to NIRP. Anyone with upside bias might consider EURUSD options trades for expiry well into January if a EURUSD squeeze develops, as the calendar may be playing a role in keeping the USD elevated into year end. On the other hand, if the market is mispricing how serious the Fed is about to get and Powell and company bulldozes over market expectations with a signal that tapering can’t end soon enough and we should price perhaps four rate hikes for next year, we could see another USD surge – two-way risks abound.