If we expect the Fed to raise its interest rates next week, there is a great deal of uncertainty regarding the pace of the U.S. monetary policy beyond this meeting. Alin Latu, Country Manager Romania at iBanFirst explains.
There is little doubt that the Federal Open Market Committee (FOMC) will hike interest rates by 0.25 % next week, bringing it up to 5.00-5.25%. Based on futures contracts, 93% of investors expect this outcome. This would represent a continuation of policy from the Fed’s March rate hike of 0.25%, which itself was a continuation of policy from the February meeting. What is coming next is more uncertain, however. Prior to the December 2022 meeting, the Fed raised short-term rates at an unprecedented pace. Then, they decided to slow the process of tightening, initially because inflation was showing signs of receding but more recently due to the banking stress.
iBanFirst also anticipates that the Fed will continue quantitative tightening at the current pace. The iBanFirst analysts do not think that a technical tweak to the Fed’s overnight repurchase agreement facility is forthcoming either. This is helping to bring needed liquidity to the financial sector.
Most analysts expect that the Fed will drop reference to “some additional policy firming” in the post-meeting statement in a signal that the Fed tightening cycle may be at its end. This makes sense for four reasons:
- The peak in inflation is undeniably behind us.
- There are early signs that the labor market is less tight.
- We bet the FOMC will want to avoid tightening too much monetary policy at a moment banking stress remains a key issue for most regional banks.
- The Fed will need to cut rates by year-end as a recession likely sets in.
Futures traders are forecasting a first easing at the November 1st FOMC meeting. This is up to change depending on the evolution of the economy, of course. iBanFirst specialists forecast the following:
- Firstly, a mild recession will happen in the second semester 2023 in the US.
- Secondly, the first-rate cut will come soon after this economic and employment drop.
From a market perspective, even a mild recession brings a messy period for risky assets – typically equities. We are not convinced that FAANG earnings are acyclical, for instance. This will push investors to look for safe haven and the market reaction will likely be positive for the US dollar once the recession is confirmed. Traditional cyclical analysis isn’t working, as we have seen recently. Most of the developed economies are facing massive cross-currents. In addition, market pricing seems disconnected, which is more the case between equities/bonds than in the FX market, nonetheless.
The current risk appetite in financial markets (with skyrocketing equities and a weak dollar) is the only typical thing happening ahead of a recession. Very often, risk appetite is increasing on prospect of a Fed pause. But risk appetite will likely turn into risk aversion when US employment contracts, which is when the Fed starts to cut.
Sometimes, there is even a brief risk appetite rally after the first Fed cut (the narrative is basically that the Fed will save us). Then reflexivity kicks in. Broad job losses will bring macro reflexivity and questions about whether the Fed cuts will be sufficient to break this dynamic. But it will take time before it happens. The timeline is probably around the end of this year or in early 2024.
In the meantime, the current market dynamics will probably remain intact – with strong risk appetite and a downward trend for the US dollar. That’s why we still believe the EUR/USD cross can still climb up to 1.15 this year before the Fed decides to step in. Currently, the EUR is hovering around 1,10 which is rather weak on a historical basis. But it is not so far from its all-time high based on a trade weighted basis – which is basically economists’ parlance for effective exchange rate. In our view, the positive momentum will continue in the short- and medium-term.