Fed playbook: 4 possible scenarios for markets from the September FOMC decision

• Federal Reserve decision expected to deliver 25bps after material repricing in bonds since the July meeting decision to stand pat

• Markets are looking for a credible move to control inflation after Fed chair Kevin Warsh turned a lack of forward guidance into an absence of reaction function clarity

• A 25bps hike could control the long end and boost equities, but aggressive policy reshaping could signal risk-off

Market implied odds are around 93% for the Fed to hike rates by 25bps to 3.75%-4.00%, the first hike since 2023. This reflects a build-up in inflation pressures seen in the official data and market-based measures of forward inflation from higher energy prices as the situation in the Middle East darkens.

Specifically, the August CPI report was the final shoe to drop after months of signs that inflation was not cooling off. Core CPI at +0.29% month-on-month is twice 0.17% trend rate required to bring annual inflation back down to 2%. The Waller Line was crossed.

Markets are braced for impact with the 2yr carry spread (the difference between the fed funds effective rate and the 2yr yield) sitting around 104bps. With some recent flattening in the curve the front end may arguably be pricing in too much hawkishness from the Fed and the back end is likely to go out further come what may, particularly as so much is driven by real rates, not solely inflation concerns. This may actually favour some resteepening trades. The long end could be marching off into the sunset either way – productivity growth in the US, crowding out effects from the AI capex supercycle, fiscal deficit risks, and the Iran war impact on energy. So much is going on a lot depends on whether this is one-and-done or the start of a new hiking cycle.

Today's statement will be accompanied by a fresh set of economic projections and the so-called dot plot that shows where policymakers think rates will be in the future. In July the FOMC voted 9-3 to hold rates steady, with three dissenters favouring a hike amid persistent inflation pressures. Since the CPI report for August the aggressive repricing in bond markets, particularly in the long end of the Treasury yield curve, suggest the FOMC will swing behind a hike today. US 10yr Treasury yields have hit their highest since 2007 this week at 5%.

In terms of projections there could be some tinkering around with growth (lower), inflation (higher) and unemployment (?) forecasts but these are unlikely to be seen as material to the market reaction. The dot plot should be more important to market expectations, particularly if there is a material hawkish shift from the June outlook, which projected some easing next year.

The Fed seldom does 'one-and-done' so I believe this to be the start of a hiking cycle with at least one more hike this year and a couple more in 2027.

Dots to watch:

The median fed funds rate projection from the June meeting SEP was 3.8% this year, declining to 3.6% in 2027 and 3.4% in 2028. Markets will look to what extent FOMC members are adjusting their skew upwards as to whether this looks like one-and-done or the start of a hiking cycle with broad alignment within the committee.

Two, the longer run rate, currently at 3.1% - where do FOMC members think the r-star (the theoretical neutral rate) should be? at 3.1% for the longer run dot it implies r-star is 1.1%, subtracting the 2% inflation target from the level. If the longer-run dot moves up significantly we can read this as a much more hawkish signal from the FOMC than markets were expecting from this hike; ie that that policy rates require a material shift higher, something bond market are already telling the Fed.