Will the Fed disappoint markets?

Summary:

• Federal Reserve is broadly expected to stay on hold in January
• Central bank could suggest a pause in monetary tightening, a balance-sheet reduction is of interest for investors
• Markets can be disappointed if the Fed avoids clear declarations

The first Federal Reserve meeting in 2019 is taking place today and it will be the first one with a press conference without presenting macroeconomic projections at the same time (this change was announced in mid-2018). An increased volatility on financial markets and slowdown concerns resulted in expectations for much more dovish Fed - are they warranted?

Market at odds with the Fed

Since the meeting in December we have seen massive repricing of the Fed’s rate path. While the central bank suggested last month that it expected two rate hikes this year and another one in 2020, markets were much less optimistic. Based on the Fed fund futures there was no rate hikes priced in for 2019. Since then, market expectations have evolved to the downside suggesting that the Fed would stay on hold this year (in the meantime we have seen even a rate cut being on the cards in 2019). For the following year there are odds the US central bank will be forced to slash rate (14% chance it will happen in January 2020). Such disbelief shared among market participants could theoretically limit the downside for the greenback but the problem is the dollar is overvalued from a historical perspective and could find few reasons to rally without more interest rate hikes.

Reverse QE: too early to end it?

The Fed’s balance sheet remains elevated even as it has shrunk 10% from the peak. Source: Bloomberg, XTB Research

In recent weeks Federal Reserve members, both doves and hawks, has expressed the same notion that the US central bank needs to hold off on raising borrowing costs in order to assess the impact from previous rate hikes on the economy. They may have been prompted to share such the outlook due to surrounding fears regarding the global economic slowdown. The US is not an exception as a fading tax cuts’ effect as well as losses caused by a trade war with China are expected to weigh on GDP this year.

Having said that, it would not be prudent to expect the Fed to declare that rates are not going to be increased. At the same time, the Fed keeps reducing its balance sheet at the pace of $50 billion per month (so called reverse QE) so even without more hikes we experience tightening. Markets would ideally see the Fed declaring no more hikes and a target date when the balance sheet reduction ends or at least pauses. However, it may be far too early for the Fed to make such an official U-turn - just a month after the last interest rate hike.

Market reaction

US indices like US500 staged a V-shaped recovery in January and expectations for more dovish Fed were among the key reasons behind this renewed optimism. These were hopes - now it’s a delivery time for the Fed. A lack of details and language that is too vague could potentially disappoint investors. Looking at the US500 chart we can see that a rally has stopped below 2675 points - now a resistance level, while the key support is located at 2600 points.  

Source: xStation5