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FOMC Preview: Rate hike with dovish bias expected

Markets are overwhelmingly expecting a 25-basis-point interest rate hike from the US Federal Reserve when it concludes its two-day FOMC meeting on Wednesday. Futures markets as of Tuesday morning have priced-in an extremely high probability of this rate hike occurring – over 99%. The key question now is how the Fed will characterize the US economy given some rather disappointing economic indicators, including tepid GDP growth and a weaker employment landscape than had been expected.

Underwhelming US Economy

Economic sluggishness in the US is showing little sign of rebounding in the second half of 2017. Expectations had previously been high that President Donald Trump would spur a rise in annual GDP growth to 3% or even 4% (as Trump had promised in his pre-election campaigning), but current indications are still showing an outlook of only around 2%.

From an employment perspective, US job creation in May was a substantial disappointment at 138,000 jobs added against a prior consensus forecast of around 180,000. Additionally, revisions for previous months further weighed on the overall employment picture – March’s very weak 79,000 jobs added (previously already revised down from 98,000) was further revised down to 50,000. April’s previously better-than-expected 211,000 was also revised down – to 174,000. Despite estimates that the US economy may be at or near full employment, these revisions put the average job gains over the past three months at a relatively weak 121,000 per month.

Fed Expectations

From the Fed’s perspective, these and other data points are likely to weigh on the outlook for interest rate hikes going forward. Whereas market expectations earlier in the year had been for three or four hikes in 2017, this has now decreased to only two, with a greatly reduced potential for three.

Aside from the Fed’s outlook for rate hikes, traders will also be paying close attention to any mention of reduction in the Fed’s massive balance sheet. Minutes of the early-May FOMC meeting, released in late-May, provided indications that the Fed would take gradual steps in shrinking its $4.5 trillion balance sheet. If there is any announcement on Wednesday of an imminent start to this reduction, it could make a significant impact on markets. In particular, there is strong speculation that any planned schedule of balance sheet reduction would significantly lower the chances of further rate hikes by the Fed going forward. Equity markets continued to rally after the last FOMC meeting minutes were released, encouraged by the Fed’s talk of “gradual” balance sheet reduction. At the same time, the dollar fell.

Market Reaction Potential

On the upcoming Wednesday FOMC decision, a few scenarios are possible. The most likely scenario, as mentioned, would be an announcement of a rate hike with a dovish outlook for future hikes. In this scenario, since a June rate hike has already been fully priced-in, the dollar should be further pressured, potentially extending the general slide that has been in place for the past month. Stocks, on the other hand, should continue to be well-supported in this event. A less likely scenario that consists of a rate hike with an unexpectedly more hawkish-than-expected outlook should push the dollar higher, potentially alleviating pressure and resulting in a likely USD rebound. The least probable scenario would be that the Fed refrains from raising rates at all on Wednesday, defying all market expectations. In this unlikely event, the dollar should see a substantial drop, as overwhelming market anticipation will have been severely disappointed.

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