Fed to Clarify How Patient it Could Get With Rate Hikes

Fundamental analysis of Forex market

The Federal Open Market Committee (FOMC) has two main things to clarify at the end of its two-day policy meeting on Wednesday at 1800 GMT. First is the course of rate hikes that the central bank hinted it will pause until later this year. Then is the size of the balance sheet and particularly policymakers’ willingness to continue winding down asset holdings at a time when risks to the global economy are skewed to the downside. New economic projections released on the same day could reflect the Fed’s appetite for further monetary tightening in coming months.

The last time the central bank gathered in late January, policymakers decided to leave interest rates steady and adopt a patient approach on future changes, explaining that, while economic conditions in the homeland are still healthy, there is no rush to move forward with hike plans yet as rising uncertainty in US-Sino trade relations, Brexit, and China’s and Europe’s growth slowdown could drain expansion in the US. Note that GDP growth weakened further to six-month lows in the fourth quarter as expected.

Following the GDP release, subsequent data showed a mixed picture for the US economy. On the demand side, the figures backed stronger inflation pressures for the coming months as wages reached their highest growth since 2009 in February and the unemployment rate returned below 4.0% despite a minimal increase in job positions. On the supply front, though, the sentiment remained negative with industrial production easing, ISM Manufacturing PMI slipping to the lowest in almost three years, and trade deficit widening the most in a decade.

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The evidence combined with elevated external risks could potentially keep policymakers cautious when revising their growth and inflation forecasts on Wednesday, probably pushing some of them lower on the famous dot plot chart that presents the number of rate hikes foreseen by FOMC members in the future. In such a case, the Fed would likely signal one rate hike for 2019, from two penciled in December, or none at all, as some FOMC members have already suggested, urging the need for more patience until further notice. Meanwhile in the markets, investors have a different opinion as they see no rate increases until early 2020. Instead they have translated the Fed’s “wait-and-see” new behavior into a rate cut, pricing a probability of 42% for such an action by January 2020.

Besides rates, comments on the balance sheet could also play a significant role on investors’ sentiment after the Fed chief Jerome Powell said that the $50 billion monthly rundown in Treasuries and mortgage-backed securities will end this year, increasing speculation that a timetable could be announced as soon as this week. The Fed started the reduction process in October 2017 when the balance sheet stood at more than $4.5 trillion and the economy was in better shape. But the Fed is now in a dilemma on how far it could go with trimming or otherwise where it should end it (in $2 trillion or $1.5 trillion?), as any aggressive decline could disrupt the financial system and cut growth while money go out of the market.

Turning to FX markets, investors wouldn’t be very surprised if the dot plot shows one rate hike or none for 2019 as the gap in rate expectations between the FOMC board and market players would narrow. But still would react depending on how dovish the language in the rate statement would be and how cautious Powell sounds at his press conference. If the tone turns unexpectedly more negative, then USDJPY could bottom within the 111-110.60 area. Negative momentum could appear even stronger if the Fed decides to stop reducing its balance sheet.

Alternatively, if policymakers appear optimistic that the economy is still resilient enough to afford two rate increases this year and one in 2020, then USDJPY would rebound with scope to test the congested area between 111.60-112. Higher, the rally could also pause at 112.75.

Fed chief Jerome Powell’s press conference is scheduled to start at 1830 GMT on Wednesday.

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