FOMC Preview: Looking Past A Hike

Expectations In Place For A Hike

As we approach the keenly anticipated December FOMC, expectations are fully fixed on the Fed lifting interest rates for the first time in 10 years, indeed the CME group are pricing an 83% probability of lift-off. With the market so highly expectant of a lift-off being enacted at this meeting the real question comes down to how the US Dollar will react to this event and on that subject there seems to be two schools of thought.

Two Camps

The first believe that a rate hike is fully priced in to the market and recent Dollar strength over the last few months is a clear demonstration of that. As a hike is so priced in the, the focus is set to be on the Fed’s guidance as to the future path of rates following an initial increase, believing that the Fed will maintain it’s outlook for continued low inflation and stress a gradual path for rates, delivering a “Dovish Hike” by lowering the 2016 “dot-plot” which should see the US Dollar lower after lift-off; either immediately lower or lower after an initial reaction higher.

The second camp are ignoring the potential ramifications of a more gradual path for rates following lift-off and believe simply that the Fed raising rates for the first time in 10 years is strongly USD bullish and will spark further upside in the Dollar.

Inflation Expectations

The key to which camp you fall in here really lies in how you view the outlook for global growth and inflation next year. The Fed’s projected path for rates following inflation is largely a function of their inflation and growth outlook. So whilst the Fed may maintain a cautious and subdued outlook at this point in time, a faster-than-expected rebound in inflation, driven by a sharp correction in energy and commodity prices, could fuel a steeper path for rates, seeing the US Dollar in higher demand. Indeed, a “Dovish Hike” with the Fed raising rates by the expected 0.25bps but lowering the dot plot for 2016 may present a great opportunity to buy USD at a discounted level if you anticipate that the inflation environment will rebound faster-than-expected next year narrowing the proximity of a second increase in rates.

The Fed themselves have noted that “Given the persistent shortfall in inflation from our 2 percent objective, the Committee will, of course, carefully monitor actual progress toward our inflation goal as we make decisions over time on the appropriate path for the federal funds rate” which also means that if inflation surprises to the downside over 2016 the pace and path of future increases may indeed be slower and shallower.

Market Response

Indeed, market response to a lift-off is of key concern to the Fed who are wary of the consequences of a sharp increase in USD. The lower path for rates which the Fed is expected to deliver is intended to contain the market response and avoid the adverse chain of reaction which could be sparked if investors sense a steeper tightening path and panic. The recent FOMC minutes release highlighted the Fed’s appreciation of this dynamic whereby they noted that “Participants also indicated that the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of underscoring this view at the time of lift-off.”

Indeed, whilst a lift-off this week is now looking almost certain there is still a significant amount of uncertainty regarding the path that rates will take following the initial lift-off. In terms of increasing short-term interest rates after a prolonged period at zero we only have the Great Depression period and World War 2 to look at, making the analysis a little tricky. We can however look at the market response to the most recent periods where the Fed has initiated a tightening cycle.

Past Lift-Off Dates

In 1994 and 2004 the Fed raised rates after extended periods of low or declining interest rates.  1997 & 199 saw the Fed increase rates during periods of already high interest rates.  So what were the outcomes of these interest rate increases?

In April 94  USD traded lower following lift-off with losses extending as US fundamentals began to weaken shortly after lift-off, prompting markets to fear that the Fed’s tightening would derail the US economic recovery.

94

In March ’97 the Fed raised rates at a time when the USD was one of the G10’s highest yielding currencies. USD  gained steadily throughout the rest of the year fuelled mainly by the risk-off environment driven by the Asian financial crisis of Summer ’97.

97

In June ’99 the Fed again raised rates during a period of already high rates. USD suffered in the months following the lift-off though it regained positive ground into year end and continued to trade higher during 2000.

99

In June ’04 the Fed raised rates and again USD sold off following the lift-off remaining weak throughout the rest of the year amid growing concerns over the path of the US economy with national debt increasing rapidly and export income undershooting import expenditure.

04

The response to the start of these tightening cycles is notable as three of the four lift-off’s saw USD weaken.  Only in the wake of the Asian financial crisis of ’97 did USD experience broad gains following lift-off.   Looking at this data suggests that the path for USD, as proclaimed by USD bulls, is not particularly clear cut and indeed if anything suggests that once the initial market reaction is digested, players should look for USD shorts as a near-term play.

The Fed is currently expected to make a further two rate increases over 2016 and to adopt a “data-dependant” approach as to the timing and size of said increases although the Fed have stated time and time again this year that path for these projected increases is to be “gradual”.  The guidance for future increases is crucial to the trading decisions formed on the back of tomorrow’s meeting and whilst market expectation is for a Dovish accompaniment to a hike with a shallow projected path for rates the minutes from the Fed’s most recent meeting noted that “while participants’ most recent economic projections suggested that a gradual increase in the target range for the federal funds rate…these adjustments thus could be either more or less gradual than the Committee currently anticipates” essentially buying themselves some deniability if rates do indeed take a steeper path next year.

Trade Ideas

The variables in tomorrow’s events with regard to changes to the statement and the rate-path projections make clear cut trading ideas a difficult task and whilst it may be tempting to position into the meeting in the hopes of a scoring a huge win, it really is a lottery and so I prefer to head into the meeting sidelines. Trying to decipher how the market will respond to the various outcomes it could be faced with tomorrow seems foolish and so instead I am identifying some levels that I will be looking to engage if price meets them based along general themes.

AUDUSD

  • The long term trend remains heavily bearish in AUDUSD and current price action is likely to prove to be simply another area of consolidation before a continued move lower.
  • IF USD appreciates to the extent that the rising channel support is broken I will sell targeting a move down into new lows.

AU1

  • Again, in appreciation of the longer term bearish trend I will look to sell AUDUSD but from higher levels
  • If USD does weaken in response to tomorrow’s outcome, for example in response to a lowered inflation outlook and shallow rate-path projection, it may offer good opportunity to position at better levels for a continued pus higher next year.
  • If AUDUSD trades back up into the .7530-76 area I will be monitoring price action and Order Flow for a short entry. The area has strong structural resistance, as well as local channel resistance and key Fibonacci resistance from the April high.

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Final Note

So far we have only considered outcomes within the parameters of the Fed raising rates this week. CME group are pricing an 83% probability of lift-off, The Fed themselves have signalled a hike at their December meeting and all the Investment Banks are geared for a hike. At times like this it feels unnervingly tempting to take the opposite side and say that the Fed won’t hike. As I stated earlier however, I am not interested in predicting the outcome, just looking for a trade-able reaction.  If it were to be that the Fed actually disappoint markets yet again by failing to raise rates this year then a swift decline in USD is to be expected

EURUSD

  • If the outside chance comes in and the Fed delay hiking, EURUSD should quickly gravitate back up toward 1.15.
  • A break back above the rising trend line from year to date low, which acts as resistance, and the key 1.10 area structural resistance area is a good buying opportunity.
  • A move back up into 1.15 makes a nice target as the apparent upper limit of the ECB’s tolerance band.

eu1