The rate decision and comments from the Federal Reserve promise to be the highlights of a week full of releases. The market has no doubt that the pause in policy tightening is here to stay, with interest rate futures pricing in a near 100% chance of an increase. Comments from Fed officials in recent weeks have removed all intrigue, showing a consensus to keep policy on hold to collect more data.
All the intrigue and potential for market movement is focused on sentiment about the path forward. According to the latest data, markets are pricing in a 29% chance of a December hike, which was recently as low as 20%.
Meanwhile, the US economy continues to generate much better-than-expected numbers and gain momentum. Just look at the GDP growth rate of almost 4.9% in the last quarter; Before the pandemic, we last saw this in 2014. What a stark contrast to expectations of a recession!
In such an environment, Federal Reserve chief Jerome Powell has no choice but to continue threatening markets with his willingness to raise interest rates further if inflation rises. And it seems to me that these potential threats should be open enough to reach markets that do not believe in new increases and are pricing in a first cut as soon as next summer.
These are perfectly reasonable predictions, but they require a sharp cooling to materialize soon. And that requires scaring the markets beyond belief. If Powell can convince the markets at the press conference that he is not lying when he threatens another hike, it will be the best news for the dollar.
The US dollar saw a slow but steady recovery until early October. There was a pause pending critical economic data and central bank decisions. This situation opened the way for movement in both directions.
Therefore, in case of a real threat of a rate hike, the US dollar rally may receive a second boost, and we will see both the initial strong boost and the subsequent gentle rise in the renewed carry trade.
In our view, tighter monetary policy will also be good news for the US bond market. It has recently suffered from falling bond prices (rising yields) on long-term bonds. However, raising short-term rates will increase the chances of an economic slowdown by lowering long-term rates, which means higher bond prices. And that's what the Federal Reserve and Treasury need now.
The main question, in our view, is whether Powell will be able to convince the Fed that his threats are serious (if they are, of course), given that the credibility of the Fed chair's words has been undermined by his rhetoric too harsh. in 2018 and too soft in 2021. In the first case, he promised more rate hikes when the market was already showing signs that it was collapsing.
The stock collapse and turmoil in the interbank lending market forced a change of course. The most recent episode of “transient inflation” is perhaps something everyone remembers. This is why the Fed now finds it difficult to manage market expectations and must do more than it credibly could.
The FxPro Analyst Team
