Fed Preview: A dovish last hike?

• The Federal Reserve is in a difficult position, facing elevated inflation, a tight labor market and a nascent banking crisis.
• Expectations went in a few days from a 50 bps hike to rising odds for no change.
• What matters for the US Dollar: systemic risks or yields?

 
Less than two weeks ago, the Silicon Valley Bank (SVB) failed, marking the beginning of a banking crisis that is unfolding. Since then, a voice has been absent, the Federal Reserve. When the crisis emerged, FOMC officials were in the blackout period. The only public communication from the Fed had been several statements about the SVB situation and announcing global coordinated action to provide liquidity via swap line arrangements.

On Wednesday, markets will hear from the Fed for the first time. The US central bank must also announce its monetary policy decision and release new macroeconomic forecasts. Following Fed Chair Jerome Powell's testimony before the Senate two weeks ago, markets started to consider the possibility of a larger rate hike in March, reinforcing the view of “higher for longer” interest rates. A few days later, thanks to the banking turmoil, a 50 bps hike is off the table, and the odds for a no change are not irrelevant. Rate cuts before year end are priced in.

There has been a shock and market participants are still figuring out how it could hit the economy, employment and inflation. The Fed is also doing the same. But there is considerable uncertainty for all. If the Fed reacts on Wednesday, showing that it is very concerned and keeps rates unchanged because of the current crisis, it would probably not trigger a celebration but most likely spread fear to markets, triggering sharp declines in the stock, sending the US Dollar initially down, but then sharply higher, amid systemic risk fears. It happened during the 2008 financial crisis.

The problem for the FOMC is that they have to decide and project amid too many uncertainties surrounding the outlook. The market knows that what the central bank says on Wednesday is soon absorbed unless it is something that shocks.

What to look for:

• Decision on monetary policy. The Fed is expected to raise its policy rate by 25 basis points to the range 4.75%-5.00%. However, some banks call for no change and a few for a rate cut.
   
• Summary of Economic Projections (SEP), the “dot plot”. It would show how FOMC members see the current crisis affecting the economy and how the central bank would react in such a scenario. As the situation unfolds, the projections could change dramatically at the next release, but that won’t matter on Wednesday. Analysts will focus on potential rate cuts scenarios before the end of the year.
   
• Powell press conference. Powell could add to the data-dependent mantra, a crisis dependent, not committing to a specific action in the future. It would be a surprise with inflation still elevated (the Consumer Price Index declined from 6.4% to 6% YoY in February and the core rate from 5.6% to 5.5%) if the Fed prioritizes stabilizing financial markets, putting aside the battle against inflation. Both objectives will likely be priority number one.
  
  During the press conference, markets could respond significantly if Powell speaks about possible rate adjustments in either direction. Particularly if he suggests that they would react if financial conditions tighten further.
  
  How Powell answers questions about the importance of lending conditions on Fed’s decisions is critical. Lending standards have already tightened and will likely keep going up. The problem is that financial conditions are subjective and quick to move. For example, just weeks ago, indicators of financial conditions were near their loosest in a year, and then went straight forward to the most restrictive in years.

 The decision, the dot plot and Powell’s words will show markets how the FOMC assesses the impact of recent volatility. That is crucial to the future interest rate outlook. 

 Unintended consequences
 

 – Extreme volatility. A rate cut or no change could create immediate shocks; also, a 50 bps hike.  With the financial world and traders looking at the Fed meeting, any outcome could trigger extreme volatility. Large price swings seem likely at the time of the announcement and during the first half of Powell’s press conference. The Fed would not want to trigger unintended consequences, but there always are. Markets could make a large story out of one word from Powell. Such influence could last a few minutes or days, favoring sharp price swings.

 – Limited reaction. It should not be ruled out. Last week, markets remained steady after the European Central Bank (ECB) meeting. The ECB acted as expected; macroeconomic projections were made before banking jitters, and Lagarde spoke carefully. The difference is that markets will hear from officials for the first time since the crisis, and the projections have to consider recent developments, and Powell is not Lagarde.
If the Fed acts as expected by raising rates and offers a cautious message, saying not much but the necessary, considering the uncertain outlook with high inflation, the reaction could be limited. The lack of clear forward guidance in the wake of the banking crisis, could contribute to markets not knowing where to go.

 – Risk on/Risk off.  If the Fed makes the dovish rate hike, it could help bring in some risk on, at least for a while. A no-rate hike, or a more dovish than expected tone, is likely to be cheered by markets but equally, that might not be the case. If markets see a frightened Fed, the fear could spread, leading to a rally in bonds, declines in Wall Street, a mixed US Dollar and probably a rally in Gold.

A decline in US yields weighs on the US Dollar. Even during the recent episode of risk aversion, the Greenback fell, as US yields sank. However, going into the future, with markets already pricing in a dovish Fed for the second half of 2023, a new rally in Treasuries could not be harmful to the Dollar if the key drivers are global systemic risks.

In the event of an unlikely “hawkish” Fed (a 50 bps hike), the initial reaction would likely be a US Dollar rally. The move's sustainably would depend on the message and the policy outlook. A “large last hike,” is not the same as a large hike keeping the doors open to more. A “hawkish” Fed could have a small positive impact on markets if it reflects confidence from the central bank that the ongoing banking crisis will not impact the economic outlook.

Surrounding events and economic data could soon overshadow the FOMC’s message, making the impact of the Fed meeting short-lived. A precise, clear, long-lasting forward guidance could be the Fed’s desire, but unachievable under current circumstances.