The week ahead: what to expect from the Fed/ECB?

Summary:

• Fed to hike rates, dot-plot, Powell to be critical for market response 
• ECB could announce QE taper on Thursday
• EURUSD rebounded from the key support, further gains more challenging

It’s not that common to have the two most important calendar events in a month to be separated by less than 24 hours so traders really will be on alert in anticipation of potentially game changing decisions. In this analysis we point out what the banks could do but also what’s been already discounted by the markets - the base you need to have to form your trading strategies. 

The FOMC (Wednesday, decision and materials 7pm GMT, conference 7:30pm)

The Fed is broadly expected to increase interest rates and to be honest - why wouldn’t they? Let’s cut through the data from the March meeting (last hike): employment gains were decent, unemployment rate declined to the XXI century low of 3.8%, inflation picked up and high oil prices pose a risk of the second round effects (where higher inflation translates into wage pressures), demand looks solid and business activity indicators remain firm (in a stark contrast to Europe). There’s just no reason not to continue with the monetary tightening and if anything the Fed could consider making a pause in September - ahead of elections in the US (November 6). 

Markets expect interest rate hike in June but moves in September and December are less certain. Source: Bloomberg  

From a trader’s point of view the hike is pretty much a done deal and is unlikely to affect currencies materially. What matters is an outlook for the next 2 meetings: as you can see investors have priced in only 1/3 chance of the 4th rate hike in 2018 for December. That would leave some upside for the dollar in case this 4th hike becomes more likely. 

 Do not be misled by a higher median rate for 2018 - Board members may still prefer 3 moves this year and long run expectations may remain broadly unchanged. Source: federalreserve.gov, XTB Research

But will we see it more clarified by Wednesday? That’s the big question. Remember, the FOMC uses a so called dot-plot where its members paint their rate expectations. In March  6 of them saw a rate of 2-2.25% (in US the Fed uses corridor and not a single rate like elsewhere) which equals 3 hikes in 2018 and 6 saw 2.25-2.5% corridor, representing 4 hikes. The median, being interpreted as the market consensus, was at 2-2.25% only because of "outliers" (3 other members). Now with a general improvement in macro outlook it would be reasonable to assume that at least one of the dots moves higher and moves the "consensus" to 2.25-2.5% corridor as a result. Nevertheless that could be less hawkish than it sounds. Markets know that the dots are not equal and our educated guess is that dots of the 3 board members (Powell included) and NY’s Dudley are on the lower side of the spectrum. Furthermore please do notice that FOMC estimate of a so called long-run rate is between 2.75 and 3% and unless there’s a noticeable move higher (and if you assume that fiscal expansion that is helping the economy at present has only a temporary impact you may be cautious here), this estimate is rather low compared to 10-year bond yields.

Therefore, it may all boil down to the post meeting conference where we’d be inclined to expect somewhat cautious approach from Powell, as he’d be wary not to roil the markets with his remarks. The Fed policy could yet turn out to be a boon for the greenback later in the year if the economy stays on track, but not necessarily at this meeting.   

The ECB (Thursday, decision 12:45pm GMT, conference 1:30pm)

The ECB decision is simple - do nothing. In this case it’s all about expectations regarding future policy. To increase interest rates in 2019 the Bank needs to stop the QE program first. Let’s recall that the program has been designed to run until the end of September with a general understanding that it would be phased down during the final quarter of the year. But markets need this on paper and expect such clarification on Thursday. 

Markets see a chance for the rate hike late in 2019 in the EMU. Source: Bloomberg 

The ECB is in a tricky position. Although inflation rebounded in May (partly on the back of energy prices), business indicators have pointed to a steady deceleration. Furthermore, Italy offered a good sample of what may happen when the bond purchase program ends. Having said that, some key figures from the Bank hinted at this meeting calling it "pivotal" and thus a declaration regarding the QE program has been pretty much fully discounted (limiting upside for the euro from this source). When we look expectations we can see that not a single rate hike in 2019 enjoys at least 50% probability so technically there’s a lot of upside. It’s just that the ECB has no reason to inflate these expectations now. 

EURUSD

The pair has rebounded from the key 1.15 support zone on two themes: reduced risk in Italy and speeches from the ECB members. Because the Fed meeting looks to offer a 2-way outcome (depending mostly on Powell’s conference) and the outcome of the ECB meeting could be perceived as being already consumed investors could assume that it would be harder for the EURUSD to maintain the momentum this week. However, when it comes to central banks emotions often cause pretty wild moves (even if only in a short run) so anything’s possible.    

EURUSD saw huge declines over April and May but managed to defend the key support zone (that used to work as a resistance before). Source: xStation5