Market participants are looking beyond the November rate decision for this week’s FOMC policy meeting. A fourth consecutive 75bps rate hike seems to be well expected, but the hopes of a pivot have seen markets rally in October and is really the key debated issue this week. There have been hopes that the Fed will signal smaller hikes from December and prepare the ground for rates to peak and pause at 4.5-5.0% in 1Q23. Reasons behind this include some softening of stance from other global central banks such as the Reserve Bank of Australia (RBA), Bank of Canada (BOC) and the European Central Bank (ECB). Liquidity stress emerging in the Treasury market has also been touted as one of the reasons for the expectations. The US Treasury Department plans to issue USD550bn in debt in 4Q22, more than the USD400bn estimated in August.
We think the following key points will be key at the November policy meeting from a markets perspective:
December rate hike talk
Dovish expectations that have been set in currently include Powell clearly guiding for a 50bps rate hike in December rather than a 75bps. We believe this will be premature, and at best what we can get is Fed to become data-dependent. Anything that even keeps the possibility of another 75bps rate hike open at the December meeting will be a hawkish surprise.
Terminal rate projections
Terminal rate forecasts are currently the largest driver of US yields. As expectations of terminal rates surged above 5% at one point in October, 10Y US yields tested cycle highs. That probably was a trigger for the Fed to use the whisperer and convey peak hawkishness in an October 24 WSJ article which first mentioned the idea of the Fed downshifting to a path of smaller rate hikes. But easing of financial conditions since then has possibly again made the central bank uneasy. This gives us a sense that the Fed is uncomfortable with an over 5% terminal rate being priced in, and we are still close to that level at 4.96% currently. But we still have more than two full rate cuts priced in by the markets for 2023, and that is where the Fed can still push back. If the Fed makes a clear case of rates staying at the peak until late 2023, that will be considered hawkish in our view, and result in risk off again.
Concerns around financial stability
With the economy still holding up well, there is little concern yet that Fed’s rate hikes will break anything in the domestic US economy. Instead, any risk of breaking things is still in the global financial markets. Too much focus on financial stability also risks shifting expectations to a Fed pause, and may be considered dovish.
Inflation and unemployment
There would be no update to the dot plot at the November meeting. It is right to consider that the Fed will have to slow the pace of rate hikes at some point. But is a softer inflation a necessary condition to reach that stage? Or we need to just wait for inflation to stop getting worse, even if it takes time to actually go lower. The core CPI and PCE data reported recently continues to show that inflation remains uncomfortably high, and any indication of commitment to still bring that down to much below 3% might potentially require a much higher unemployment rate and possibly much more pain in the financial markets.
The US dollar is 3-4% off its highs amid these Fed pivot expectations. With dovish expectations having set in, there is potentially room for the USD to surprise on the upside. That would mean EURUSD back below 0.98 and USDJPY taking another go at 150. USDCNY also would be poised for a move to 7.40 unless these rumours of China considering an exit from its Zero Covid policy by March 2023 prove to be true.
However, if these dovish expectations were to materialize, we could see EURUSD heading to 1.02 and USDJPY down at sub-145 levels. While the Japanese yen may sustain these gains as yield differential pressures start to ease, EUR may have a tougher time holding on to the recovery as room for ECB rate hikes is also decreasing and the energy crisis can only get worse from where we are in this winter.
The most ideal reaction for the equity markets will be to stay in a sideways trend. With markets eager for any bullish trends, the risk of a technical rally remains if the Fed clearly closes doors for any more 75bps rate hikes from here. However, if the markets rally too hard on any Fed communication, we will likely see a host of Fed speakers in the coming weeks trying to clarify and assert that the Fed maintains a hawkish stance, as easing of financial conditions isn’t what the Fed wants right now. The market moves need to remain orderly for the Fed to achieve its inflation goal, else any hopes of a Fed pivot will continue to be smashed.