While bond and currency traders still see a Federal Reserve rate hike Wednesday as all but baked in, the latest disappointing U.S. inflation report has them tearing up their guidebooks for how to react to the central bank’s policy decision.

Summary: 

• The FED is expected to raise rates despite weaker data from the US economy
• The central bank publishes its economic forecasts today, with dot-plot as the most important part
• FOMC could also signal its plans on the balance sheet reduction

Analysis:

The rate hike is a done deal, at least according to the interest rates market. Traders see a 90% chance of such move today, which shouldn’t be seen as a big surprise. FOMC members indicated in their speeches that a rate hike could be an appropriate idea, despite a streak of weaker data from the US economy. Today’s reports were more than disappointing, but that shouldn’t derail tightening plans. The central bank rarely surprises the market. What’s more, it could be even said that the FED follows the market, not the opposite. That is why a dovish message could be found elsewhere.

 It doesn’t mean, however, that the outcome of the meeting will be hawkish. What’s more, there’s quite a big chance of a dovish move from the central bank. Let’s focus on the economic projections. The FED signaled in its last dot-plot that rates will be raised 3 times in 2017, 2018 and 2019 and that the long-term rate is expected between 2.75%-3.00%. Recent disappointments could lead, however, to a lower rate path and to a weaker dollar as a result. According to the major banks the Federal Reserve won’t lower its rate path projection, so any downward move in dots will be painful for the dollar. There’s a chance that today’s dot-plot will point to a lower long-term rate and could signal only two hikes next year. If so, yields could tumble, pushing the greenback lower.

 The FED saw three hikes in 2018 and 2019. There’s a chance that the median could be lowered after a streak of weaker data. source: Bloomberg

Finally, it’s worth looking at the FED’s statement and Yellen’s press conference. The statement could probably signal that the recovery continues, but also that a progress in inflation slowed. “Quantitative tightening” is another interesting aspect. It is believed that the central bank will begin its balance sheet reduction later this year and that such move could be announced as soon as September. If so, then the FED could use today’s meeting to prepare the market for such scenario. What’s more, an indication could also appear during Yellen’s press conference. We think that the FOMC’s chairwoman will try to be cautiously optimistic given a potential hike  It won’t be enough, however, to support the dollar if projected rates move lower.

Conclusion:

Recent data was much weaker than expected, but the FED will probably stick to its plan and hike rates. Such scenario is already priced in, so the focus will be elsewhere. The crucial part for the USD will be the dot-plot that could show a lower path of rate hikes in the future. The market sees a small chance of such outcome which could lead to a negative reaction of the USD. On the other hand, if the central bank doesn’t change a thing, the dollar could pare some of its recent losses. 

Markets worth looking at ahead of the meeting.

Trade scenarios ahead of the FED.