Markets Bets on Dovish Fed May Be Disappointed. Will They Care?

Talking Points:

Currency markets singularly focused on Fed policy announcement
FOMC to note recent market turmoil, pro-tightening fundamentals
Traders’ taste for wishful thinking to guide market-wide response

All eyes are on the Federal Reserve monetary policy announcement in the hours ahead. The rate-setting FOMC committee is broadly expected to keep the benchmark lending rate unchanged this time around. Indeed, priced-in probability of an increase is a mere 14.3 percent. This puts the spotlight on the text of the statement accompanying the rate decision and the forward guidance contained therein.

Investors appear positioned for a dovish outcome having scaled back 2016 tightening bets amid risk aversion since the beginning of the year. In fact, markets shrugged off yesterday’s selloff in China – a development that might have been expected to send traders scrambling just weeks ago – to deliver a strong performance across sentiment-geared assets (as expected). Gold rose alongside stocks while the US Dollar fell, reinforcing the likelihood that the move was Fed-inspired.

For its part, the Fed will have to attempt a difficult balancing act. On one hand, it will have to acknowledge recent market turmoil as well as softening US growth dynamics in the final months of 2015. On the other, it will have to re-focus investors’ attention on mandate-relevant fundamentals and establish the possibility of tightening in March. This is necessary so that such a move, if deemed appropriate, does not trigger an overly violent response.

On balance, the case for policy normalization remains compelling. Realized and expected inflation is firming: the latest readings on core year-on-year CPI and hourly earnings growth registered at multi-year highs while 2-3 year breakeven rates have trended upward since August. On the jobs front, the unemployment rate is at the lowest level since 2008 and nonfarm payrolls growth is running at a reasonably brisk pace, with the 12-month trend average at 220k.

This means that the Fed statement will have to reassure investors that it will adjust policy if market stress infects the real economy. In the same breath, it will have to explain that as of now, the projected rate hike path has not materially changed since the first post-QE rate hike in December.

The markets’ subsequent reaction will depend on the degree of wishful thinking that traders are prepared to entertain. If they emphasize the first point – a possible result considering the dovish shift in expectations in spite of the aforementioned fundamental evidence – risk appetite is likely to strengthen. This will see the stocks rising alongside sentiment-geared currencies like the Australian and New Zealand Dollars while the greenback as well as the anti-risk Euro and Yen decline. A focus on the second point will probably deliver the opposite result.

Will the US Dollar rise for a fourth year in 2016? See our forecast here!

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