FOMC Meeting Preview: Dovish Dreams may not Come True

The Fed is expected to deliver a 50 bp rate hike on December 14, continuing to meticulously dampen inflation pressure in the economy. However, the chances of a recession that markets price in continue to rise, as evidenced from the bond prices recovery and dollar sell-off. This undermines the Fed's efforts to ease price pressures. The Fed's hawkish message is likely to go unheeded unless the data starts to prove the central bank right.The market consensus for a 50 bp tightening appears to be strong enough – Fed funds rate futures price in this outcome with a 75% chance, while only 25% is given to an aggressive 75 bp outcome:After raising rates by 375 bp since March, including a series of 75 bp hikes, Fed stated that it made "substantial progress" in achieving its tightening goals and the time to slow down the pace nears. This wording was used in the minutes of the November Fed meeting. However, Fed chief Jerome Powell and his team have gone out of their way to point out that, despite smaller steps, "terminal rates should be somewhat higher than suggested during the September meeting." As such, the Fed should be concerned about the recent sharp drop in Treasury and dollar yields, coupled with the narrowing credit spreads that make borrowing cheaper and thus fueling monetary expansion in the economy — the exact opposite of what the Fed wants to see as it tries to curb inflation. The market reactions described above came in response to a relatively weak CPI growth in October, which was 0.3% m/m compared to the consensus forecast of 0.5%. The Fed's preferred measure of inflation, the core deflator for personal consumption spending, was even softer, rising just 0.2%. However, this is only one month of favorable data, while the market is already pricing in a rapid decline in inflation on the horizon of one year so the risk of repricing of those expectations is high:In order for inflation to be around 2% in a year, average monthly gain should be 0.1-0.2%. This is likely to be the key message that the Fed will try to convey to the markets at the upcoming meeting. With current market expectations, this could be interpreted as a hawkish message. With this in mind, the Fed is likely to keep raising rates in 2023, and its new forecasts should point to a higher trajectory to 5%, with a possible slight upward revision in short-term GDP in nominal terms, driven primarily by inflation. But the adjustment will also be justified by real indicators – the consumer sector is holding up well, the employment growth rate is definitely not a recessionary one, which supports incomes, and hence consumer spending. The market will know about the November inflation on December 13 – the day before the FOMC meeting – and the result will be important for what the Fed says. If the core consumer price index turns out to be at or above the consensus forecast of 0.3% m/m, the market is likely to listen to the Fed's message with more attention. If inflation softens and yields fall even further, then the Fed will have to act more decisively and perhaps start talking about accelerating quantitative tightening – selling assets from the balance sheet, in order to somehow convince the market. The Fed should now be inclined to stick to hawkish statements until it is sure that the specter of high inflation has completely disappeared. The dollar has fallen significantly against a basket of major peers over the past two months. Negative and positive developments for the dollar had an asymmetric effect – surprises in inflation led to much stronger selloffs than were rebounds on strong data such as the NFP. The hope for the dollar bulls now is that the positioning is much better balanced after the 8% drop in the trade-weighted dollar and the 12% drop in USD/JPY. The dollar did not nosedive, probably because expectations of further rate hikes remain priced in. The terminal rate is still estimated to be close to 5%, with only a 50-bps cut expected in the second half of 2023. If the Fed does not say that what will clearly signal the imminent end of the tightening cycle, the bottom of the dollar may already be somewhere close. The EUR/USD pair is holding on in the 1.05 area as the gap between markets’ expectations from the Fed plans is not wide. A more dovish reversal would be unexpected and seasonally adjusted against the dollar in December the pair could rise above the 1.06 resistance to the 1.07 area in low-liquid markets later in the year. At the beginning of next year, the EURUSD uptrend may finally start to reverse.


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