FOMC: Considering ‘considerable’

  • Market expects the FOMC to change its forward guidance as a signal it is ready to raise interest rates in 2015
  • Risk of a ‘buy the rumour, sell the fact’ effect suggesting potential for a modest USD sell-off
  • The Fed may err to keep in the forward guidance of ‘considerable time’
  • Any removal of ‘considerable’ could see the dollar briefly rally. However risk assets could sell-off hard, Yellen could soften the blow at the press conference and the dollar end up handing back its gains.

Financial markets are not expecting the Fed to begin tightening rates until 3Q15 (specifically, end July)

Here at LFX a useful tool we like to take advantage of for a quick perspective of Feds Fund Rates forecasts is the CME group’s Interest Rates Implied Probability product, this tool gives a great read on the markets perspective of the likelihood of Fed Funds rates and actions over the next 12 months.

Further, if you listen to Fed speakers, the “considerable time” part of the Fed statement text implies a 6-month gap until the first Fed rate hike. So the gap is currently 7 months if markets expectations are correct – but is this close enough for the Fed to drop this phrase, and are there other considerations?

The starting point is probably the labour market. And here, the market’s perceptions are still likely coloured by the strong November payrolls report. Fed labour market conditions indicators still point to the existence of some lingering slack, however. And since this seems to be the Fed’s benchmark for when the time comes to pull the trigger on rates, the market sees this as another minor hint for no change

The other clue is the headline inflation rate. This is out later today, the same day as the Fed decision, the market sees a good chance of a fall in the inflation rate – possibly below the consensus estimate of 1.5%YoY.  Now admittedly, this is mainly an oil price effect, and core inflation is unlikely to show the same level of weakness. But the Fed has centred the price stability element of its policy around headline, not core inflation. And further declines in headline inflation are virtually guaranteed.

The final piece of the puzzle is comments from Fed officials themselves. Clearly, the hawks still see a need for imminent tightening. So it is the doves that will be the swing voters in any shift in policy. Notably few of these have made the news with comments in the last few weeks. The most memorable of whom was Dennis Lockhart, who suggested that rates would not be shifted at this meeting.

Markets seem largely in agreement too, so we will probably only see a small market reaction (front end Treasury curve rallies, USD softens, US equities rally) if the decision goes the way the market thinks.  A decision to drop the “considerable time” reference would be more of a shock, and deliver a larger (and opposite) market reaction.

FX Implications & Trading Conditions

A few weeks ago the market was positioned for the dollar to be on its highs going into this all-important Fed meeting. But a variety of global event risks such as Greek politics and particularly the Rouble collapse has prompted a round of profit taking after a good year for risk assets – and taken some shine off the dollar.

There are plenty of fresh inputs today. Not only will the market be looking at whether the ‘considerable’ reference is retained, but also the ‘Dot’ diagram.

2014-12-17 11_11_57-fomc's september dot chart - Bing Images

In March the fact that the Dots tended to coalesce around 1% – suggesting confidence in higher rates had lifted the dollar. The Fed is well aware the market looks at Dots, so may be reluctant to centre a new set of end 2015 forecasts at 1.50% for end 2015.

Even though markets are very positive on the dollar:  heavy long dollar positioning,
were the Fed to retain ‘considerable’ or  remove ‘considerable’ would probably trigger a sharp sell-off in risk assets in the current environment – all suggesting the dollar will likely struggle to hold gains on the day.

USD2014-12-14 20_52_43-pdfnews.asp (JPEG Image, 909 × 594 pixels)

A final and critical point to consider from a short term trading perspective, is that since the beginning of last week, e-commerce FX dealers have been complaining about the lack of liquidity and the fact that it’s only going to get worse heading into the holidays and the new year.

Tonight’s FOMC meeting and press conference will only serve to heighten the fear factor which will further detract from liquidity. Wherever the stop-losses are, that’s where the market will likely gravitate towards. Getting ‘married’ to logical fundamental or technical positions can be very costly at this time of year. We would suggest using the big  swings to scale into psotions, whilst reducing overall exposure at around half normal sizing.