FOMC Decision: A 'Dovish Hike'?

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Includes: DRR, ERO, EUFX, EUO, FXE, UDN, ULE, URR, USDU, UUP
by: Citylytics

Summary

Fed will raise the target range for the federal funds rate.

Markets are more interested in future monetary policy guidance.

Fed might have to lower its growth and inflation expectations.

Implications on the rates and the EUR/USD.

After the conclusion of the meeting on Wednesday, the Fed will announce a 25 basis point increase in the target range of the federal funds rate. This will lift the range to 1.00%-1.25% and will be the fourth rate increase since the Fed began with its monetary policy normalization in December 2015. Also, such an outcome will be in line with current market expectations, whereas Bloomberg consensus survey suggests that 90% of market participants expect to see a rate increase.

With the 25 basis point rate hike already priced in, market reaction in the aftermath of the meeting will depend almost solely on the Fed's future monetary policy guidance. Therefore, we should not exclude the possibility of another "dovish hike" as was the case in March. In March, the Fed increased its target range for the fed funds rate by 25 basis points to 0.75%-1.00% in line with wide market expectations. However, the Fed surprised markets as it did not give any indication of a more aggressive pace of future rate hikes. The Fed stated the following:

"The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data."

Also, Yellen did her best to sound cautiously optimistic during the press conference after the decision. By doing so, the Fed managed to contain any undesirable USD appreciation which might jeopardize growth and inflation outlook. In more detail, the USD depreciated slightly versus the euro (from 1.0627 the day before the decision to 1.0715 in the aftermath of the decision). Also, 10Y USD rates declined from 2.60% to 2.49% in the same day.

On Wednesday, the Fed will also release updated economic and financial forecasts. The previous ones were released in March and it seems that the economic outlook has deteriorated somewhat since then. Also, inflationary pressures have eased recently, causing the ECB to lower its inflation expectations at its last meeting as well. The Fed argued that the growth slowdown in the first quarter owes only to transitory factors. Let us not forget that GDP growth decelerated from 2.0% yearly in 4Q16 to just 0.7% yearly in 1Q17. Also, PCE inflation declined from 2.1% in February to just 1.7% in April. At the same time, personal consumption growth decelerated from an average 4.9% increase in the 1Q to 4.3% in April. The May CPI and retail sales data reports are scheduled to be released on Wednesday. If disappointing, the Fed may even have to admit that the slowdown is not just a transitory thing.

Table 1: Fed forecasts

Variable

2017

2018

2019

Real GDP growth

2.1

2.1

1.9

Unemployment rate

4.5

4.5

4.5

PCE inflation

1.9

2.0

2.0

Source: Fed statement

There is a high chance the Fed will revise its growth and inflation expectations downwards for the current year. But even if the Fed opts for only minor cosmetic changes to the outlook, I believe that they will do their best not to sound too optimistic. After a dovish stance in March and surprisingly low inflation in the recent period, the Fed has no reason to give the market a hint of either faster or stronger policy tightening for the time being. Moreover, with growth and inflation on shaky ground, the last thing the Fed wants is a stronger dollar. That being said, the Fed will probably reiterate their intention of gradual normalization of interest rates.

When the Fed raised rates in March, yields on the long end were rising before the meeting, only to fall sharply in the aftermath of the press conference. But the 10Y US Treasury rates have recently fallen to the lowest levels since November, only to marginally increase in the past few days. It seems that the market is currently more prepared for a dovish Fed. That is why we haven't seen any stronger yield rise in spite of the fact that 90% of market participants expect to see a hike. In such circumstances, and despite my expectation of a more dovish Fed, I see limited room for a further fall in US Treasury yields and would recommend to short the long-end US Treasuries ahead of the meeting. The situation is similar on the FX markets as well. Usually the dollar would strengthen versus the euro ahead of the meeting when the market expected the Fed to raise rates. However, this is not currently the case. The EUR/USD continues to trade around the 1.12 mark which is the highest level since November. Therefore, the rate hike should give some boost to the dollar versus the euro.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.