Dollar cannot gain ground even as Fed projects rates above 5%
Stocks drift lower, albeit not much, as traders second-guess Fed
The central bank show continues with ECB, BoE, and SNB today
Markets skeptical of Fed guidance
The Federal Reserve raised interest rates by half a percentage point yesterday, as widely anticipated. In the updated economic projections, the message was quite gloomy as the unemployment rate and core inflation for next year were revised higher, while GDP growth was calibrated lower to almost stall speed. Hence, a worse economy all around.
What really caught the market’s attention though was the new ‘dot plot’, where 17/19 FOMC officials saw rates above 5% at the end of next year. Chairman Powell justified these hawkish forecasts by emphasizing the extremely tight labor market, strong wage growth dynamics, and potentially sticky services inflation as requiring a more heavy-handed approach on interest rates.
Despite these shock tactics, market participants were skeptical. The dollar closed the session lower, equity markets barely declined, while US yields were almost unchanged - not the tape one would expect considering how hawkish the Fed’s message was relative to market pricing.
Judging by the market reaction, investors either think that economic developments next year will force the Fed to renege on its rate promises or believe these projections were simply a strategy to tighten financial conditions, not seeing them as credible.
Delayed moves in USD and stocks
The dollar did gain some ground early on Thursday, although the fact that US yields haven’t budged suggests there might be other forces at play, for instance positioning adjustments ahead of the ECB and BoE meetings later today.
In general, the reaction function in the dollar has been asymmetric lately, with negative developments hurting the reserve currency more than positive developments boosting it, something exemplified by this week’s inflation report and Fed decision. This dynamic likely reflects just how stretched the ‘long dollar’ trade was just a few weeks ago.
Over on Wall Street, there was a delayed reaction to the Fed’s aggression. Even though the S&P 500 lost ‘only’ 0.6% yesterday in the aftermath of the decision, the mood has soured further with futures pointing to losses of around 1% at the open today, without any obvious trigger other than a disappointing batch of data from China.
Central banks galore
The Swiss National Bank also raised rates by a half-point today. The franc fell on the decision though, possibly because there were no firm signals for further rate increases, with the SNB simply saying it "cannot be ruled out".
Next on the agenda is the Bank of England. Market pricing is leaning towards a 50bps rate hike, but also assigns a 30% probability for a bigger move of 75bps. Admittedly, that’s unlikely. While inflation is still scorching hot, the BoE already expects a recession next year and business surveys suggest that’s a realistic outcome, so this is not the time to be reckless. Sterling could edge lower on a smaller rate hike and a cautious message.
Across the British channel, the European Central Bank will also unveil its rate decision today. The setup is very similar to the BoE - markets expect a 50bps move, but with a nearly 30% chance for heavier action. Energy prices have declined and the Eurozone is also grappling with recession risks, making a 75bps move appear unnecessary. A 50bps move could bruise the euro initially, but whether the common currency stays down might depend on whether the ECB also announces plans to reduce its balance sheet next year. If so, the euro could erase any early losses and perhaps trade higher overall.
On the data front, the latest edition of US retail sales could also be important.